Unit - 1 National Income and Determination of National Income

Unit:1
National Income and Determination of National

Income
Prepared by: Dr. Taral Patel
National Income Prepared by: Dr. Taral Patel 1

Outline of Chapter
Introduction, Definition of National Income Factors determining National
Income.
Concepts of National Income: Gross National Product (G.N.P), Net
National Product (N.N.P), National Income or National Income at Factor
Cost (N.I), Personal Income (P.I), Disposable Income (D.I).
Measurement of National Income
Significance of National Income Statistics.
Determination of National Income:

What is this?

Introduction
• National income is an uncertain term which is
used interchangeably with national dividend,
national output and national expenditure. On
this basis, national income has been defined in
a number of ways.
• In common parlance, national income means
the total value of goods and services produced
annually in a country.

Definitions of National Income
• The definitions of national income can be

grouped into two classes: One, the traditional
definitions advanced by Marshall, Pigou and
Fisher; and two, modern definitions.
• According to Marshall: “The labour and capital of
a country acting on its natural resources produce
annually a certain net aggregate of commodities,
material and immaterial including services of all
kinds. This is the true net annual income or
revenue of the country or national dividend.”
National Income Prepared by: Dr. Taral

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Cont..
• A.C. Pigou has in his definition of national
income included that income which can be
measured in terms of money. In the words of
Pigou, “National income is that part of
objective income of the community, including
of course income derived from abroad which
can be measured in money.”

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Cont..
• Fisher adopted ‘consumption’ as the criterion of
national income whereas Marshall and Pigou
regarded it to be production. According to Fisher,
“The National dividend or income consists solely of
services as received by ultimate consumers, whether
from their material or from the human environments.
Thus, a piano, or an overcoat made for me this year is
not a part of this year’s income, but an addition to the
capital. Only the services rendered to me during this
year by these things are income.”
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Modern Definitions
• From the modern point of view, Simon
Kuznets has defined national income as “the
net output of commodities and services
flowing during the year from the country’s
productive system in the hands of the ultimate
consumers.”

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National Income Factor Determining
• Land
• Labor
• Capital
• Organization
• E:\College Work\2020-21\odd semester\Principles of Ec
onomics -II\Unit 1
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• E:\College Work\2020-21\odd semester\Principles of Ec
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Income Flow diagram in detail analysis

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Income Flow Diagram

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Concepts of National Income
(A) Gross Domestic Product (GDP):
• GDP is the total value of goods and services
produced within the country during a year.This
is calculated at market prices and is known as
GDP at market prices. Dernberg defines GDP
at market price as “the market value of the
output of final goods and services produced in
the domestic territory of a country during an
accounting year.”
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NDP
• NDP is the value of net output of the economy
during the year. Some of the country’s capital
equipment wears out or becomes obsolete each
year during the production process. The value
of this capital consumption is some percentage
of gross investment which is deducted from
GDP. Thus Net Domestic Product = GDP at
Factor Cost – Depreciation.

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• Net National Product (NNP):
• NNP includes the value of total output of consumption
goods and investment goods. But the process of
production uses up a certain amount of fixed capital.
Some fixed equipment wears out, its other components
are damaged or destroyed, and still others are rendered
obsolete through technological changes.
• All this process is termed depreciation or capital
consumption allowance. In order to arrive at NNP, we
deduct depreciation from GNP. The word ‘net’ refers to
the exclusion of that part of total output which
represents depreciation. So NNP = GNP—Depreciation.

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• NNP at Market Prices:
• Net National Product at market prices is the
net value of final goods and services evaluated
at market prices in the course of one year in a
country. If we deduct depreciation from GNP
at market prices, we get NNP at market prices.
So NNP at Market Prices = GNP at Market
Prices—Depreciation.

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Personal Income:
• Personal income is the total income received by the
individuals of a country from all sources before
payment of direct taxes in one year. Personal income
is never equal to the national income, because the
former includes the transfer payments whereas they
are not included in national income.
• Personal income is derived from national income by
deducting undistributed corporate profits, profit
taxes, and employees’ contributions to social security
schemes. These three components are excluded from
national income because they do reach individuals.

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• Disposable Income:
• Disposable income or personal disposable
income means the actual income which can be
spent on consumption by individuals and
families. The whole of the personal income
cannot be spent on consumption, because it is
the income that accrues before direct taxes have
actually been paid. Therefore, in order to obtain
disposable income, direct taxes are deducted
from personal income. Thus Disposable
Income=Personal Income – Direct Taxes.
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Methods of Measuring National Income:
• Product Method:
• According to this method, the total value of final goods and
services produced in a country during a year is calculated at
market prices.
• To find out the GNP, the data of all productive activities,
such as agricultural products, wood received from forests,
minerals received from mines, commodities produced by
industries, the contributions to production made by transport,
communications, insurance companies, lawyers, doctors,
teachers, etc. are collected and assessed at market prices.
Only the final goods and services are included and the
intermediary goods and services are left out.
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Income Method:
• According to this method, the net income payments
received by all citizens of a country in a particular
year are added up, i.e., net incomes that accrue to all
factors of production by way of net rents, net wages,
net interest and net profits are all added together but
incomes received in the form of transfer payments
are not included in it. The data pertaining to income
are obtained from different sources, for instance,
from income tax department in respect of high
income groups and in case of workers from their
wage bills.
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• Expenditure Method:
According to this method, the total
expenditure incurred by the society in a
particular year is added together and includes
personal consumption expenditure, net
domestic investment, government expenditure
on goods and services, and net foreign
investment. This concept is based on the
assumption that national income equals
national expenditure.

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Difficulties of Measurement Special
Difficulties of Measurement in Under-
developed Countries.
• (A) Problems in Income Method:

• 1. Owner-occupied Houses:
A person who rents a house to another earns rental
income, but if he occupies the house himself, will the
services of the house-owner be included in national
income.
The services of the owner-occupied house are included in
national income as if the owner sells to himself as a
tenant its services.
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• 2. Self-employed Persons:
• Another problem arises with regard to the income of
self-employed persons. In their case, it is very
difficult to find out the different inputs provided by
the owner himself. He might be contributing his
capital, land, labour and his abilities in the business.
• 3. Goods meant for Self-consumption:
• In under-developed countries like India, farmers keep
a large portion of food and other goods produced on
the farm for self-consumption. The problem is
whether that part of the produce which is not sold in
the market can be included in national income or not.

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• 4. Wages and Salaries paid in Kind:
• Another problem arises with regard to wages and
salaries paid in kind to the employees in the form
of free food, lodging, dress and other amenities.
Payments in kind by employers are included in
national income.

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• (B) Problems in Product Method:
• 1. Services of Housewives:
The estimation of the unpaid services of the
housewife in the national income presents a
serious difficulty. A housewife renders a
number of useful services like preparation of
meals, serving, tailoring, mending, washing,
cleaning, bringing up children, etc.

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Patel
• 2. Intermediate and Final Goods:
• The greatest difficulty in estimating national
income by product method is the failure to
distinguish properly between intermediate and
final goods.
• There is always the possibility of including a
good or service more than once, whereas only
final goods are included in national income
estimates.

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Patel
• 3. Second-hand Goods and Assets:
• Another problem arises with regard to the sale
and purchase of second-hand goods and assets.
• We find that old scooters, cars, houses,
machinery, etc. are transacted daily in the
country. But they are not included in national
income because they were counted in the
national product in the year they were
manufactured.
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• 4. Illegal Activities:
• Income earned through illegal activities like
gambling, smuggling, illicit extraction of wine,
etc. is not included in national income.
• Such activities have value and satisfy the
wants of the people but they are not
considered productive from the point of view
of society.
• But in countries like Nepal and Monaco where
gambling is legalised, it is included in national
income.
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Patel
• 5. Consumers’ Service:
• There are a number of persons in society who
render services to consumers but they do not
produce anything tangible. They are the actors,
dancers, doctors, singers, teachers, musicians,
lawyers, barbers, etc. The problem arises about
the inclusion of their services in national
income since they do not produce tangible
commodities.
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• 6. Capital Gains:
• The problem also arises with regard to capital
gains. Capital gains arise when a capital asset
such as a house, some other property, stocks or
shares, etc. is sold at higher price than was
paid for it at the time of purchase. Capital
gains are excluded from national income
because these do not arise from current
economic activities.

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etc..
• Depreciation
• Price Changes

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(C) Problems in Expenditure Method:
• (1) Government Services:

• In calculating national income by, expenditure
method, the problem of estimating government
services arises. Government provides a
number of services, such as police and military
services, administrative and legal services.

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• (2) Transfer Payments:
• There arises the problem of including transfer
payments in national income. Government makes
payments in the form of pensions, unemployment
allowance, subsidies, interest on national debt,
etc. These are government expenditures but they
are not included in national income because they
are paid without adding anything to the
production process during the current year.

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• (3) Durable-use Consumers’ Goods:
• Durable-use consumers’ goods also pose a problem.
Such durable-use consumers’ goods as scooters, cars,
fans, TVs, furniture’s, etc. are bought in one year but
they are used for a number of years. Should they be
included under investment expenditure or consumption
expenditure in national income estimates? The
expenditure on them is regarded as final consumption
expenditure because it is not possible to measure their
used up value for the subsequent years.
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• (4) Public Expenditure:
• Expenses on education, museums, public health, police,
parks, street lighting, civil and judicial administration are
consumption expenditure. Expenses on roads, canals,
buildings, etc. are investment expenditure. But expenses
on defence equipment are treated as consumption
expenditure because they are consumed during a war as
they are destroyed or become obsolete. However, all
such expenses including the salaries of armed personnel
are included in national income.

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Importance of National Income
• 1. For the Economy:
• National income data are of great importance
for the economy of a country. These days the
national income data are regarded as accounts
of the economy, which are known as social
accounts. These refer to net national income
and net national expenditure, which ultimately
equal each other.

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Patel
• 2. National Policies:
• National income data form the basis of
national policies such as employment policy,
because these figures enable us to know the
direction in which the industrial output,
investment and savings, etc. change, and
proper measures can be adopted to bring the
economy to the right path.

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Patel
• 3. Economic Planning:
• In the present age of planning, the national
data are of great importance. For economic
planning, it is essential that the data pertaining
to a country’s gross income, output, saving and
consumption from different sources should be
available. Without these, planning is not
possible.

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• 4. Economic Models:
• The economists propound short-run as well as
long-run economic models or long-run
investment models in which the national
income data are very widely used.

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• 5. Research:
• The national income data are also made use of
by the research scholars of economics. They
make use of the various data of the country’s
input, output, income, saving, consumption,
investment, employment, etc., which are
obtained from social accounts.

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• 6. Per Capita Income:
• National income data are significant for a
country’s per capita income which reflects the
economic welfare of the country. The higher
the per capita income, the higher the economic
welfare of the country.

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• 7. Distribution of Income:
• National income statistics enable us to know
about the distribution of income in the country.
From the data pertaining to wages, rent,
interest and profits, we learn of the disparities
in the incomes of different sections of the
society. Similarly, the regional distribution of
income is revealed.

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Determination of National Income: How the level of national Income is
Determined?
• Aggregate output in the short run

Potential output
– the output the economy would produce if all
factors of production were fully employed
• Actual output
– what is actually produced in a period
– which may diverge from the potential level

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Some simplifying assumptions
• Prices and wages are fixed
• The actual quantity of total output is demand-
determined
– this will be a Keynesian model
• For now, also assume:
– no government
– no foreign trade
• Later chapters relax these assumptions

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Aggregate demand
• Given no government and no international trade,
aggregate demand has two components:
– Investment
• firms’ desired or planned additions to physical capital &
inventories
• for now, assume this is autonomous
– Consumption
• households’ demand for goods and services
• so, AD = C + I

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Consumption demand
• Households allocate their income between
CONSUMPTION and SAVING
• Personal Disposable Income
– income that households have for spending or
saving
– income from their supply of factor services (plus
transfers less taxes)

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• Consumption Function:
The positive relationship between consumption spending and disposable income is described by the
consumption function. (Or)
Consumption function expresses the functional relationship between aggregate consumption
• expenditure and aggregate disposable income, expressed as:
C = f (Y)
• a) The private demand for goods and services accounts for the largest proportion of the
aggregate
demand in an economy and plays a crucial role in the determination of national income.
• b) According to Keynes, the total volume of private expenditure in an economy depends on the
total
• current disposable income of the people and the proportion of income which they decide to spend
• on consumer goods and services.
• c) The consumption function, proposed by Keynes is as follows:
C = a + bY
Where, C = aggregate consumption expenditure;
Y = total disposable income;
a is a constant term i.e. the positive value of consumption at zero level of disposable income; b, the
slope of the function, (ΔC /ΔY) is the marginal propensity to consume

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The Keynesian Consumption Function

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From the above graph:
• a) The consumption function shows the level of consumption (C)

corresponding to each level of
• disposable income (Y) and is expressed through a linear consumption
function, as shown by the
• line marked C = f(Y)
• b) When income is low, consumption expenditures of households will
exceed their disposable
• income and households dissave i.e. they either borrow money or draw
from their past savings to
• purchase consumption goods.
• c) The intercept for the consumption function, a, can be expressed as a
measure of the effect on
• consumption variables other than income.
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Conclusion:
• The Keynesian assumption is that

consumption increases with an increase in
disposable income, but
• that the increase in consumption will be less
than the increase in disposable income (b < 1).
i.e. 0 <
• b < 1.

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IN A TWO SECTOR MODEL ECONOMY:
• 1. AGGREGATE DEMAND (AD): In a simple two-sector economy aggregate demand (AD)
or
aggregate expenditure consists of only two components:
• a) Aggregate demand for consumer goods (C), and
• b) Aggregate demand for investment goods (I)
AD = C + I
• Of the two components, consumption expenditure accounts for the highest proportion of
the GDP.
Assumptions:
• i) Investment ‘I’ is assumed to be determined exogenously and is constant in the short
run.
• ii) The income of the consumer must be either spent or saved and hence,
Consumption is a function of income i.e. C =f(Y) and also
Saving is a function of income i.e. S=f(Y).

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• Relation between income and consumption: As the theory
of the consumption-income
relationship also establishes the saving-income relationship,
the concepts of Consumption
Function, MPC; APC; Saving Function; MPS; and APS are to
be considered for the explanation.
• 3. Consumption Function:
Consumption function expresses the functional relationship
between aggregate consumption
expenditure and aggregate disposable income, expressed as:
C = f (Y)
• According to Keynes the consumption function is as follows
C = a + bY

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Cont.

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• From the above graph
• a) The 45° line (Y = C+I) is drawn to split the positive quadrant
of the graph and shows the incomeconsumption
• relation with Y = C (AD = Y) at all levels of income.
• b) All points on the 45° line indicate that aggregate
expenditure (C+I) equal aggregate output (Y);
• and the line maps out all possible equilibrium income levels.
• c) As long as the economy is operating at less than its full-
employment capacity, producers will
• produce any output along the 45-degree line that they believe
purchasers will buy.
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• DETERMINATION OF NATIONAL INCOME BY
USING TWO SECTOR MODEL:
• According to Keynesian theory of income
determination, the equilibrium level of
national income is a
• situation in which aggregate demand (C+ I) is
equal to aggregate supply (C + S)

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• 1. AGGREGATE DEMAND (or) AGGREGATE EXPENDITURE (AD):
a) The aggregate demand (C+ I) refers to the total spending in the
economy i.e. it is the sum of demand for the consumer goods (C) and
investment goods (I) by households and firms respectively.
• b) Aggregate demand represents realized value by the households
• c) Aggregate demand depends on households plan to consume and
to save.
• d ) The AD curve is linear and positively sloped indicating that as the
level of national income rises, the aggregate demand (or aggregate
spending) in the economy also rises.
• e) The AD line is flatter than the 45-degree line because, as income
rises, consumption also increases, but by less than the increase in
income.
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Cont.
• 2. AGGREGATE SUPPLY (or) AGGREGATE INCOME(AS):
• a) Aggregate Supply refers to the total supply of goods and services available in
a market from
• producers.
• b) Aggregate supply represents aggregate value expected by business firms
• c) Aggregate supply depends on the producers’ plan to produce goods and
services.
• 3. Equilibrium will be established at a point where: The aggregate demand is
equal to the
• aggregate supply (or) The aggregate expenditure equals aggregate income (or)
The
• households’ plan must coincide with producers’ plan (or) Expected value by the
firms
• equals realized value by the households.

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Schedule for AD and AS
Y( Income C S (Saving ) I AD=C+I AS=C+S Remark
) (Consump (Investme
tion ) nt)
0 40 -40 40 80 0
100 120 -20 40 160 100
200 200 0 40 240 200
300 280 20 40 320 300
400 360 40 40 400 400 Effective
demand:
AD=AS
500 440 60 40 480 500

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Effective demand: AD = AS

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Cont.
• Reasons why other points (rather than Y0) on the graph are not points of
equilibrium:
a) At Y1 (level of income below Y0) the aggregate demand exceeds income; i.e
the (C +1) schedule is above the 45° line. Equivalently, at all those levels I is
greater than S, as can be seen in panel (B) . Excess demand makes businesses to
sell more than what they currently produce. The unexpected sales would draw
down inventories and result in less inventory investment than business firms
planned. They will react by hiring more workers and expanding production. This
will increase the nation’s aggregate income. It also follows that with demand
outstripping production, desired investment will exceed actual investment.
b) At Y2 (levels of income above Y0), output exceed demand (the 45° line is
above the C +I schedule). The business firms would be unable to sell as much of
their current output as they had expected. It shows that they made larger
inventory investments than they planned and their actual inventories would
increase. Therefore, there will be a tendency for output to fall. This process
continues till output reaches Y0 (where there is no tendency for output to
change).

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Equality of Saving and Investment:
• There is another way of determining the equilibrium level of NI,
i.e., through equality of savings and investment.
• Take the same diagram of AD and AS. At point E, the savings and
investment are equal to GE. At above the point the saving is more
than investment, and for income less than this point, the investment
is more than saving. Saving and investment are only equal at the
equilibrium level of income, and when they are not equal, the NI is
not in equilibrium.
• When at a certain level of NI intended investment by the
entrepreneurs is more than intended savings by the people, this
would mean that AD is greater than total output or AS, i.e.,
• I > S or AD > AS
• P: 100 H: + 20S =AS
• H: 100 : + 40 I = AD
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Cont..
• This would induce the firms to increase production raising the
level of income and employment.
• Hence, when at any level of NI, investment is greater than
savings, there will be a tendency for the NI to increase.
• On contrary, when at any level of NI, the investment demand is
less than saving, it means that AD is less than AS. As a result of
a decline in national output, the national income will also reduce.
• Saving is withdrawal of some money from the income
stream. On the other hand, investment is the injection of money
into the income stream. If the intended investment is more than
intended saving, it means that more money has been injected in
the economy. This would increase the national income.

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• But when investment is just equal to saving, it
would mean that as much money has been put
into income stream as has been taken out of
it. The result would be that the NI will neither
increase nor decrease, i.e., it would be in
equilibrium. The determination of NI by
investment and saving is illustrated in the
following diagram:

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Cont..

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• In the above diagram, the investment line (II
curve) has been drawn parallel to the X-
axis. This is done on the assumption that in
any year, the entrepreneurs intend to invest a
certain amount of money. That is, we assume
that investment does not change with income.
• The saving line (SS curve) shows intended
saving at different levels of income.

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• The saving line (SS curve) shows intended saving at different
levels of income.
• The saving line and investment line intersect each other at the
equilibrium point E, where the intended saving and the intended
investment are equal at OY level of income. Hence OY is the
equilibrium level of NI.
• In the above diagram, there is no tendency for income to increase
or decrease.
• If the income level is greater than OY, the amount of intended
investment is less than saving, as a result, the income will finally
decrease.
• If the income level is less than OY, the amount of intended
investment is greater than intended saving, as a result, the income
will continue to increase to the equilibrium level.
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Inflationary Gap
• Inflationary gap arises when consumption and investment spending together are greater than the full
employment GNP level. This means that people are demanding more goods and services than can be
produced. In other words, the implication of inflationary gap is that national income, output and
employment cannot rise further.
• The only consequence of increased demand is that the price level will increase. Or we may say that
there will be an inflationary gap if scheduled investment tends to be greater than full employment
saving. In a situation like this, more goods will be demanded than the economic system can produce.
• The result will be that price will begin to rise and an inflationary situation will emerge. Thus, if full
employment saving falls short of scheduled investment at full employment (which means that peoples’
propensity to spend is higher than the propensity to save), there will be an inflationary gap.
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Inflationary Gap

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Deflationary Gap:
• The deflationary or recessionary gap is the

amount by which the aggregate expenditure
falls short of the full employment level of
national income. It causes a multiple decline in
real NI.

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Cont..
• In the above diagram, Y is the total output at
full employment level. Let us assume that the
total demand is (C + I + G)’ which cuts the
45o line at B, with real output Y’, AB then is the
deflationary gap.

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Patel

Unit - 1 National Income and Determination of National Income

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Unit - 1 National Income and Determination of National Income

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Unit:1

National Income and Determination of National

Prepared by: Dr. Taral Patel

National Income Prepared by: Dr. Taral Patel 1

Measurement of National Income

Significance of National Income Statistics.

Determination of National Income:

National Income Prepared by: Dr. Taral Patel 2

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• The definitions of national income can be

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• (A) Problems in Income Method:

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• (1) Government Services:

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• Aggregate output in the short run

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• a) The consumption function shows the level of consumption (C)

• The Keynesian assumption is that

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National Income Prepared by: Dr. Taral

National Income Prepared by: Dr. Taral

National Income Prepared by: Dr. Taral

National Income Prepared by: Dr. Taral

employment cannot rise further.

National Income Prepared by: Dr. Taral