NATIONAL INCOME: CONCEPT AND MEASUREMENT Ogada

National income accounting is a measure of all income activities in a country valued in terms of money.

Measure of National Income

1. Gross National Product (GNP)
The value of all final goods or services produced during a specific period, usually one year, plus income earned
abroad by the nationals, minus incomes earned locally by foreigners.
We can view GNP in three different ways which all measure identically the same flow: -
a) GNP measured by expenditure on final product.
b) GNP measured by the type of income generated in production.
c) GNP measured by the way the income is used or disposed of.
The first and third give the basic GNP identity that is fundamental to the study of economics in an aggregate or macro
level.
C+ I +G+( X −M )=GNP=C +S +T + R f

2. Gross Domestic Product (GDP)

The market value of all final goods and services of one year plus income earned locally by the foreigners minus
incomes earned abroad by the nationals.
The concept of GDP is similar to that of GNP with a significant procedural difference.
In the case of GNP, incomes earned by the nationals in foreign countries are added to incomes earned locally. While
incomes earned by the foreigners are deducted from the market value of domestically produced goods and services.
But in the case of GDP, the process is reversed: - incomes earned locally by foreigners are added and incomes earned
abroad by the nationals are deducted from the total value of domestically produced goods and services.

3. Net National Product (NNP)

This is GNP less Capital Consumption allowance which includes depreciation of plants, equipment, and residential
structures.
NNP therefore gives the measure of net output available for consumption by the society (including consumers,
producers, and the government). It is the real measure of the national income.
NNP = NNI (Net National Income)
NNP is therefore the same as the National Income at factor cost.
To therefore obtain real national income, indirect taxes are deducted from the NNP
¿=NNP – Indirect taxes

Keynesian Theory of Income Determination

To explain the Keynesian Theory of Income Determination, the economy is divided into 4 sectors:
1. Household sector
2. Firms or the business sector
3. Government sector
4. Foreign sector
The theory presents income determination in the 3 models.
1. Two-sector model which includes only the household and business sectors.
2. Three-sector model including household, business, and government sectors.
3. Four-sector model which includes the addition of the foreign sector to the three-sector model.

Two-sector model
Assumptions:
1. The hypothetical simple economy has only two sectors: - households and firms. The households own the
factors of production and they sell factor services to the firms to earn their living in the form of factor
payments and wages, rent, interest, and profits.
Households are also the consumers of all final goods and services. The firms on the other hand hire factor
services from the households and produce goods and services which they sell to the households.
2. There is no government or if the government is there, it does not perform any economic function, it does not
tax, it does not spend and it does not consume.
3. The economy is a closed one. There is no foreign trade.
4. There are no corporate savings or undistributed (or retained) corporate profits i.e. the total corporate profit is
distributed as dividends.
5. Prices of all goods and services, supply of labor and capital, and the state of product technology remain
constant.
According to Keynes, the National Income of a country is determined by 2 factors:
1) Aggregate demand (AD)
2) Aggregate supply (AS) of goods and services.
The equilibrium level of NI is determined where AD=AS

Aggregate supply (AS)

Refers to the total value of goods and services produced and supplied in an economy per unit of time. It includes both
consumer goods and producer goods.
AS schedule/curve is drawn on the assumption that total income is always spent i.e. total income always equals total
expenditure.
In the Keynesian theory, aggregate income equals consumption (c) plus savings (s).
Therefore, as schedule is generally named as C + S schedule. AS curve is also sometimes called the aggregate
expenditure (AE) curve.
The Aggregate Supply Curve
Aggregate Expenditure (AE)
AS = AE=C+S

450
Aggregate Income (Y)
Aggregate Demand (AD)
This is an ex-post concept. It implies effective demand which equals actual expenditure. The aggregate effective
demand means the aggregate expenditure made by the society per unit of time, usually one year. AD consists of two
components:
i. Aggregate demand for consumer goods (C)
ii. Aggregate demand for capital goods (I)
AD=C+ I
In the Keynesian Framework, Investment (I) is assumed to remain constant in the short run while Consumption (C) is
treated to be a function of income(Y).
C=a+ bY
Where:
C: Aggregate Consumption Expenditure
Y: Total Income
∆C
b: Marginal Propensity to Consume (MPC) = .
∆Y
AD=a+ bY + I

Aggregate EExpenditure
At equilibrium;
AS = C+S

AD = C+S

450
Aggregate Income (Y)
¿
Y

From the diagram, the equilibrium level of national income is determined at a stage where the aggregate demand for
output (C + I) is equal to the aggregate supply of incomes (C + S).

AD = AS
C+I=C+S
I=S
Given these conditions of equilibrium, there are two alternative ways to show the determination of NI:
i. By using AD and AS schedules
ii. By using only savings (S) and investment (I) schedules.
The two approaches are known as the Income-Expenditure approach and Saving-Investment approach respectively.

Income – Expenditure approach

According to the AD and AS approach, the equilibrium, of NI is determined through:
C+I=C+S
Since C + S = Y the NI equilibrium condition can also be restated as
Y=C+I
But since
C=a+ bY
Therefore Y =a+bY + I
Y −bY =a+ I

Y (1−b)=a+ I

¿ a+ I
Y = Aggregate Expenditure
1−b

C+S

C+I

C
800 E

I=S=100

É C=700 I

450
800 Aggregate Income (Y)

Example
Given C=100+0.75 Y
I =100
Then
Y =C + I =100+0.75 Y +100
¿ 100+ 100
Y =
1−0.75
¿
Y =800

Once NI is determined, it will remain stable in the short run. Any production in excess of or below the equilibrium
output will create conditions for the income and expenditure to return to the equilibrium position.
Savings Investment Approach
Here the NI is determined where I=S
From the above example

C=100+0.75 Y
I =100
But Y= C + S
Therefore
S=Y −C
S=Y −(100+0.75 Y )
¿−100+0.25 Y
100=−100+0.25 Y
0.25 Y =200
¿
Y =800

Savings & Investment

S=−100+0.25 Y

100 I

0
800 Aggregate Income (Y)

-100

S & I Schedules intersect at point E where equilibrium of NI is determined at 800 which is the same as the one
determined by the Income-Expenditure approach.

Shift in AD function and the multiplier

A shift in the AD schedule, in a two-sector economy may be caused by a shift in the consumption schedule or in
investment schedule or both.
Consumption expenditure is, however, found to be more stable because it is a function of income whereas investment
may change due to autonomous factors. It is, therefore generally assumed that the shift in the AD schedule takes place
due to a shift in the investment schedule.
Let us assume that the AD schedule shifts upward due to a permanent upward shift in the investment such as the
upward shift of the AD schedule causes an upward shift in equilibrium of NI i.e. increase in NI.

C+S

Aggregate Expenditure
(AE)
C+ I + ∆ I

C+ I
E2
C=a+ bY
E1

I+∆ I
∆I I
450
Y1 Y2 Aggregate Income (Y)

∆Y

Shift in AD function & increase in NI

the increase in NI is expressed as
∆ Y =Y 2−Y 1
Which is the result of ∆ I
At equilibrium point E1 , Y =C + I
Since
C=a+ bY
Y 1=a+b Y 1 + I
Y 1−b Y 1=a+ I
¿
Y 1 ( 1−b )=a+ I
¿ a+ I
Y 1= …………………………………….. (i)
( 1−b )

Similarly, at equilibrium E2 ,
Y 2=C + I + ∆ I
Y 2=a+b Y 2 + I + ∆ I
Y 2−bY 2=a+ I +∆ I
 ¿
Y 2 ( 1−b )=a+ I +∆ I
¿ a+ I + ∆ I
Y 2= …………………………………….. (ii)
( 1−b )

Subtracting equation (i) from equation (ii) we get

a+ I + ∆ I a+ I
∆Y = −
( 1−b ) ( 1−b )
1
∆Y = ∆ I ……………………………… (iii)
(1−b )

1
Equation (iii) gives the relationship between ∆ Y and ∆ I It reveals that ∆ Y is ×∆ I
( 1−b )
1
Therefore, is the multiplier (m). The value of the multiplier can be obtained by dividing both sides of the
( 1−b )
equation by ∆ I
∆Y 1
Im = =
∆ I ( 1−b )

The multiplier may thus be defined as the ratio of the change in N1 due to a change in Investment. Since in our case
above ∆ Y is the result of ∆ I . The multiplier so defined is called investment multiplier.
∆C
Note that in the equation (iii), b stands for MPC (b= ). It may therefore be concluded that MPC is the
∆Y
determinant of the value of the multiplier.

1
m=
1−MPC
But MPS=1−MPC
1 1
m= =
1−MPC MPS
Example
MPC=0.75
MPS=0.25
1 1
m= = =4
1−MPC 0.25

Limitations of multiplier
1. Multiplier is related to the rate of MPC. If MPC is lower in an economy, the rate of multiplier will also be
low. Since MPC in a less developed country is comparatively higher, the multiplier there must be higher than
in the more developed countries. This may however not be true in real practice because of other limitations of
the multiplier.
 2. The working multiplier assumes that those who earn income as a result of certain autonomous investments
would continue to spend a certain percentage of their newly earned income on consumption and that there are
no leakages in the expenditure process. This assumption may not hold in real practice since people may like to
spend a part or whole of their additional income on:
 Payment of past debt
 Purchase of existing durable goods and other assets
 Purchase of shares and bonds
 Purchase of imported goods
These are known as leakages in the consumption flow, which reduce the rate of multiplier.
3. The working of multiplier is based on the assumption that the goods and services are always available in
adequate supply but if goods and services are in scarcity, the actual consumption expenditure will be reduced
whatever the rate of MPC. Consequently, the multiplier will be reduced.
4. Under the condition of full employment, the theory of multiplier will not work because additional goods and
services cannot be produced or additional real income cannot be generated.
Despite the limitations, the concept of multiplier is an important tool in analyzing the process and forces of
economic fluctuations in the economy. In addition, the concept of multiplier is useful in analyzing the impact of
public expenditure, taxation and through trade in the economy.

Income Determination in Three Sector Model

This economy consists of 3 sectors:
 Households
 Firms
 Government
The inclusion of the government into the model brings in two variables:
i. Government expenditure (an injection)
ii. Taxation (a withdrawal from income stream)
Assuming in a 3-sector model then
AD=C+ I +G
AS=C + S+T

Equilibrium
AD= AS
C+ I +G=C+ S+T
Y =C + I +G
Where;
C=a+ b Y d
Y d =Y −T
T : Lumpsum Tax
Y =a+b (Y −T )+ I +G
Y =a+bY −bT + I +G
Y −bY =a−bT + I + G
Y (1−b)=a−bT + I +G
¿ 1
Y = (a−bT + I +G)
1−b
Example
C=100+0.75Y
I=100
Let us also assume a balanced budget of the government
G=T=50
By substituting
¿ 1
Y = (a−bT + I +G)
1−b
¿ 1
Y = (100−(0.75 ×50)+100+50)
1−0.75
¿ C+S+T
Y =850

Aggregate Expenditure (AE)

C+ I +G

E C+ I
850

C=a+ bY

S+T

150 I + G=150
I =100
0 450
Y1 850 Aggregate Income (Y)
-150

Change in Government Expenditure and the government expenditure multiplier.

Assuming government expenditure is confined to only purchase of goods and services and that also all other variables
remain constant, the impact of change in government expenditure on the level of NI is similar to the autonomous
change in investment.
Remember

¿ 1
Y = (a−bT + I +G) …………………………………….. i
1−b
Let the government expenditure increase by ∆ G

Increase in government expenditure increases, AD through a process of multiplier. The equilibrium level of NI with
∆ G can be expressed as:
1
Y + ∆Y = (a−bT + I + G+ ∆ G) ……………………………… ii
1−b
The effect of ∆ G on the level of NI can be obtained by subtracting equation (i) from equation (ii) to get:
1
∆Y = (∆ G) ……………………………………………………. iii
1−b
Rearranging values in equation (iii) we get government expenditure multiplier (Gm) as given below:
∆Y 1
Gm= =
∆G 1−b
Note that government expenditure multiplier is the same as investment multiplier.

Change in Lump-sum tax and the tax multiplier.

Recall:
¿ 1
Y = (a−bT + I +G) ……………………………………………….. i
1−b
A change in tax by ∆ T is accompanied by a change in Y (i .e ∆ Y ¿
1
Y + ∆Y = (a−b (T + ∆ T )+ I +G)
1−b
1
¿ (a−bT −b ∆ T + I +G) ……………………………… ii
1−b
Subtracting (i) from (ii)
1
∆Y = (−b ∆ T )
1−b
−b
∆Y = (∆ T )
1−b
Tax multiplier (Tm)
∆ Y −b
=
∆ T 1−b

Note that the tax multiplier bears a negative sign which means that an increase in tax have a negative impact on the
national income.
Note that since b=MPC and MPC <1,
∆ Y −b
=
∆ T 1−b
−b 1
(Tm= )<(Gm= )
1−b 1−b
i.e. Tm is smaller than Gm

The Balanced Budget Multiplier

We have discussed the government expenditure multiplier assuming taxes(T) to remain constant and T-multiplier
assuming G to remain constant.

However, we can also consider the impact of a simultaneous change in G and T of equal magnitude on the level of NI.

When ΔG=ΔT the government budget is said to be in balance. Such an effect of balanced budget theorem of NI is
analyzed by the balanced budget theorem of balanced budget multiplier effect. The balanced budget multiplier is
always equal to one. That is why it is also called unit multiplier theorem.

1
Y= (a−bT + I +G) ………………………………. i
1−b

By incorporating ΔG and ΔT , while ΔG=ΔT and the resulting change in income, ΔY , we get the equilibrium level
of income as

1
Y + ΔY = (a−b(T + ΔT )+ I +G+ ΔG) ……………………………… ii
1−b

By subtracting equation (i) from equation (ii) we get

1
ΔY = (−bΔT + ΔG) …………………………………………… iii
1−b

Since ΔG=ΔT by substituting ΔG for ΔT we can write equation (iii) as:

1
ΔY = (−bΔG+ ΔG )
1−b

By rearranging the terms, we get

ΔY (1−b)=−bΔG+ ΔG

ΔY (1−b)=ΔG (1−b)

ΔY = ΔG …………………………………………. Iv

The balanced budget multiplier (Bm) can be obtained by dividing both sides of equation (iv) by ΔG to get

ΔY ΔG
Bm= = =1
ΔG ΔG

Bm can also be obtained by adding up the G-Multiplier and T-Multiplier:

1 −b
Bm= and Tm=
1−b 1−b

1 −b
Bm=Gm+ Tm= + =1
1−b 1−b
Note that the balanced budget multiplier (Bm) is equal to unity. It means that if ΔG=ΔT , national income increases
exactly by the amount of increase in government expenditure.

Balanced Budget Multiplier with Proportional Income Tax

We have analyzed the effects of balanced budget with an autonomous lump-sum tax. In reality however systems
consist of both lumpsum & proportional taxes.

Analyzing the effect of balanced budget with proportional income tax.

The tax function will be

T =T + tY

Where:

T : Autonomous Tax

t: Proportion of Income Tax

Equilibrium:

Y =a+b ( Y −T ) + I +G

Y =a+b ( Y −(T +tY ) ) + I +G

Y =a+bY −b T −btY + I +G

Y −bY +btY =a−b T + I +G

Y (1−b+bt )=a−b T + I +G

¿ 1
Y = (a−b T + I +G)
1−b(1−t)

Now let the government expenditure increase by ΔG , we get the balanced budget multiplier with proportional tax as:

ΔY 1
=
ΔG 1−b (1−t )

Note that the balanced budget multiplier with a proportional tax is smaller than the balanced budget multiplier with
only lump-sum tax.

Income Determination in A four Sector Model

In the four-sector model we include the foreign trade where exports are injections and imports are outflows from the
circular flow of income in the NI analysis.
Even though a number of factors influence exports, it is always assumed that those factors operate outside the
economy. In the income determination model, therefore, X is treated as an autonomous variable.

For analytical purpose, a simplified assumption is made that imports (M) depend on the level of domestic income(Y)
and the marginal propensity to import (MPM)

M =M + gY

Where: M : Autonomous Import

ΔM
g= : MPM
ΔY

Y =C + I +G+( X−M )

C=a+ b Y d

I =I

G=G

X =X

}
I =I
X =X Autonomous/constant
G=G

Y d =Y −T

M =M + gY

Y =a+b ( Y −T ) + I +G+ X −(M + gY )

Y =a+bY −b T + I +G+ X −M −gY

Y −bY + gY =a−b T + I +G+ X−M

Y (1−b+ g)=a−b T + I + G+ X−M

¿ 1
Y = ¿
1−b+ g

1
The term is the foreign trade multiplier on the assumption that consumption and imports are both a linear
1−b+ g
function of domestic income.

Foreign Trade Multiplier with Tax Function

This involves the inclusion of tax(T) as a function of income in the foreign trade multiplier. The equilibrium equation
is then written as:

Y =C + I +G+( X−M )

Y =a+b ( Y −T −tY )+ I +G+ X −(M + gY )

Y =a+bY −b T −btY + I +G+ X−M −gY

Y −bY +btY + gY =a−b T + I +G+ X−M

Y (1−b+bt + g)=a−b T + I +G+ X−M

¿ 1
Y = (a−b T + I +G+ X−M )
1−b+ bt+ g

¿ 1
Y = (a−b T + I +G+ X−M )
1−b(1−t)+ g

From the above, the foreign trade multiplier for a four -sector model in which income tax and imports are linear
functions of income is given as:

ΔY 1
:
ΔX 1−b ( 1−t ) + g

Example

Given:

C=100+0.75 Y d

I =100

G=50

T =25+0.2 Y

X =25

M =10+ 0.1Y

Determine the equilibrium national income and open economy multiplier.

Y =C + I +G+( X−M )

Y =100 +0.75 ¿

Y =100 +0.75 ( Y −25−0.2 Y )−100+50+25−10+0.1 Y

Y =100 +0.75 ( 0.8 Y −25 )+100+ 50+25−10+ 0.1Y

Y =100 +0.6 Y −18.75+100 +50+25−10+ 0.1Y

Y −0.6 Y +0.1 Y =246.25

0.5 Y =246.25

Y =492.5

The equilibrium of NI is Ksh. 492.5 billion

1
The open economy multiplier is =2
0.5