LECTURE II
NATIONAL INCOME, OUTPUT AND EXPENDITURE
The circular flow of income
The circular flow model describes the flow of resources, products and incomes among
economic actors.
For simplicity, consider an economy with only two actors; households and firms. They
interact in a circular pattern as in the diagram below
Product
Market
Households Firms
Resource
Markets
The households
- Supply resources (land, labour, capital and entrepreneurial skills) to the
resource markets and receive earnings for those resources
- Demand goods and services from the product markets. make payments for
those goods and services using the incomes they receive
The firms
- Demand resources from the resource markets for production of goods and
services
- supply goods and services to the product markets
Products and resources flow in a counterclockwise direction while payments for these
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items flow in the opposite direction
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The above case assumes an economy with no government and does not participate in
foreign trade. However, many countries trade with others and also have governments that
actively participate in the economic activities. Thus in such an economy there are 4
actors; Households, firms, government and rest of the world
Other than there being only resource and product markets there are also money markets
in the economy. a more elaborate circular flow model would therefore include all these
actors and the markets in which they interact as follows.
Rest of
M The world
I
X
G
Money C+I+G+X-M
C
S Market
Households B Firms
GNP
Disposable Government Tax
Income
Transfers
C = Consumption expenditure G = Government purchases and Spending
S = Savings M = Imports
I = Investment spending X = Exports
B = Government borrowing
Leakages
These refer to any diversion of aggregate income from the domestic spending i.e. a
withdrawal from the circular flow. They include; Savings (S), Taxes (T), and Imports (M)
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Injections
These refer to any payment of income other than by firms or any spending other than by
domestic households on an economy. These include; Investments, Government purchases
including transfers (G), Exports (X),
Three approaches to measurement of National income
(i) Expenditure Approach
Sum up all the market expenditures by final consumers including the purchases of
capital goods by the business community. we include expenditures on final goods
and services only.
AE = C + G + I + (X – M)
(ii) Income Approach
Sum up all the incomes received by individuals and firms. These include; wages,
salaries, profits, interests, rents, e.t.c. Payments or earnings for people who do not
supply goods or services (transfer payments) are excluded.
Aggregate income(Y) = w + r + i + π
(iii) Product or Output Approach
Add contributions of all individuals at each stage of production to total outputs
plus value added of each industry from public, private, and subsistence sectors.
We only consider contribution to production for each firm (Net output). The
method is also referred to as Value Added Approach.
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GDP and its related concepts
Gross Domestic Product (GDP)
The total money value of all final goods and services produced in a country during any
given period of time usually one year.
Gross National Product (GNP)
The total money value of all final goods and services produced from factors of production
owned by a country’s nationals during any given period of time regardless of where they
are located.
Net National Product (NNP)
The total output of consumer goods produced by residents plus the net increase in the
economy’s total capital stock (That is, production of new capital goods in excess of
replacement of depreciated capital goods) during any given period of time. It is computed
as follows;
NNP = GNP – Depreciation (capital consumption allowance)
National income (NI)
This refers to the total amount of income earned by the factors of production in an
economy during a certain period. it is computed thus;
NI = NNP – (indirect taxes less subsidies)
Per capita income
Refers to national income divided by the population of that particular country
Personal Income (PI)
Refers to the total income of persons or households from all sources before taxation;
computed as;
PI = NI – (retained corporate profits + social insurance payments) + (interest incomes
received by households + transfer payments to households)
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Disposable Income
Referred to as the after tax personal; incomes to households. Thus it is computed as;
DI = PI – Personal income taxes. This is the total amount of income which is available
for use by households. This money can either be saved or incurred in the form of
consumption expenditure (DI = C + S)
Summary
= GNP at market price
minus depreciation (capital consumption allowance)
= Net National Product (NNP)
minus direct taxes less subsidies
= National income (NI)
(Compensation to employees + Rental income + corporate profit + Proprietors income+
Net interests) Also referred to as GDP at factor costs
minus (corporate taxes + undistributed corporate profits + social insurance payments)
plus (dividends + interest on government debt + government transfers to persons +
business transfer payments)
= Personal income (PI)
minus Personal taxes
= Personal disposable income (PDI)
minus (Personal Consumption expenditures + Interest payments by consumers + personal
transfer payments)
= Saving (S)
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Difficulties in measuring National income
1. Incomplete Information- some important information may not be available or may
be inaccessible
2. Danger of double counting- Costs of raw materials (intermediate goods) may be
included in national income accounting
3. Unpaid services- Services that people do for themselves and others that are not
paid for are usually excluded from national income accounting
4. Depreciation- Replacement costs for worn out parts may not be considered
5. Inventory valuation- there are many methods that can be used and each may give
different results.
6. Changes in the value of money- changes in the market prices (value) of final
products due to inflation may result into changes in the measure of national
income even if real output may not have changed.
Factors determining size of an economy’s National Income
(i) Stock of factors of production in terms of both quality and quantity
- land (fertile or infertile)
- Labour (required skills or not)
- availability of good or bad infrastructure
(ii) the state of technical knowledge
- whether there is know-how or not and whether the technology is appropriate
or not
(iii) Participation rate
- proportion of economically active group compared to the general populace
(iv) political stability
- whether the country is politically stable or not
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Uses of National income accounting
Highlights information about size of various sectors in the economy. For example
GNP gives information about consumer expenditures, taxes and investments
Highlights information about economic performance of the economy overtime.
for example annual growth rates
It is an indicator of structural change (transformation) in the economy of a
country
National income and social welfare
The question asked here is that; is per capita income a good measure of material well
being of the people?
Per capita income is not a good measure of material well being of the people because of
the following reasons;
- it does not look at the distribution of income within the economy
- increased national income could be due to increased number of working
hours, implying that people do not have leisure which adversely affect their
health conditions
- It is a measure of production and consumption which are not measures of
welfare of people
- it does not consider deterioration to the environment through air and water
pollution, deforestation etc
- is a statistical device that measure changes in economic activity and thus does
not deal with quality of life
- it does not account for varying demands for different countries
- there are inaccuracies in computing statistical data thus figures for such
income =are suspect
- Changes in GNP figures can be due to changes in prices over time but not due
to changes in output
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