Topic 5 – National Income

I can use my understanding of national

income data to evaluate and to predict

changes in economic performance.

 National Income

Section A – The Circular Flow of Income

Learning Outcomes:
1. Explain how income flows between households and firms within a closed
economy and the concept of injections (J) and withdrawals (W). the circular flow
of income
2. Show that in an open economy there are three injections (Investment,
Government expenditure and Exports or I, G, X) and three withdrawals (Saving,
Taxation and Imports or S, T, M) and that a state of equilibrium is achieved when
I+G+X=S+T+M.
3. Evaluate the implications of imbalances between injections and withdrawals,
with reference to the multiplier effect, which may result in economic growth or
economic recession.

National Income is the flow of all goods and services produced in a country over a year.
The Circular Flow of Income is a means of showing how the national income is created,
and how it can be measured.

A Closed Economy
The simple model of the circular flow of income is made up of only two groups of people
called households and firms. The circular flow of a closed economy would look as follows:

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A simple circular flow of income is one where:

1. There is no government.
2. There is no trade with other countries.
3. Households spend all their income buying goods – no savings or paying taxes
4. Firms use all the money earned from selling goods to pay the factors of production.

If all income is spent on consumption, then it is clear that:

National Income = National Expenditure = National Output
In the real economy this is true, but things are rather more complicated.

An Open Economy
The real world does not include just households and firms. The diagram below shows a
circular flow that is much more realistic as it shows that:

a. Households do not spend their income on buying goods made in the country but
also on imported goods. Moreover, they also save money and pay taxes.
b. Firms use some of their income for investment (retained profits), they pay taxes,
and they buy imports from abroad.

c. The Government is involved in the economy by spending and collecting taxes.

d. Foreign countries’ citizens buy goods and services from the country
(exports) and sell goods and services to the country (imports).

Therefore, the National Income in an economy is distributed among consumption

expenditure, investment, government spending, and net exports, which includes the
value of what we produce and sell abroad minus what we spend on imports.

National Income = Final Consumption Expenditure + Investment + Exports - Imports

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FCE (Final Consumption Expenditure) is the sum of the consumption of Households (H),
Non-Profit Institutions Serving Households (NPISH) and Government (G) or FCE =
CH+CNPISH+CG.

Withdrawals and Injections

Up till now, we have assumed that all money earned (income) will be spent. However, in reality not of
all it is spend on local products as some is:
- Spent in taxes,

- Saved, and

- Spent on imports.

The above three , are called withdrawals, as they are ‘withdrawing’ money from the circular flow
of income. The reason is that if households, firms are not continuing to circulate money between
them, but save it, spend it on imports or paying it to the government in the form of taxes, then
the money is taken ‘out of the flow.’

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Injections – The opposite of withdrawals are injections. When government spends, when
companies and firms invest in capital (example buying of machinery and others) and the
country exports goods and services, these will all contribute to the circular flow of income.

In reality, it is not only local consumers that spend money in the economy as some is:

- Spent by the government,

- Invested in the economy by enterprises, and

- Spent in the economy through exports.

Aggregate Demand represents the total planned demand for goods and services in an
economy. It includes:

- Consumer expenditure on goods and services.

- Investment expenditure by firms on new equipment.

- Government spending on goods and services.

- Spending by foreigners on exports of goods and services.

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An Economy in Equilibrium

An economy is said to be in equilibrium when it is in a state of balance. So, an economy

is said to be in equilibrium when:

Withdrawals = Injections

• If Injections > Withdrawals – AD is too high.

• If Injections < Withdrawals, AD falls and stocks would accumulate.

A complete diagram of the circular flow of income

An exhaustive circular flow of income diagram is shown below. This shows that households pay firms,
to purchase goods and services. Firms ,on the other hand, to be able to produce goods and services,
need land, labour, capital, entrepreneurship provided by households. These are paid through rent,
wages, interest and profits respectively.

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Effects of Imbalances in Withdrawals or Injections on Output, Employment, and National

Income

• Economic Growth: When injections exceed withdrawals, more money circulates in

the economy, leading to increased demand, production, and potentially higher
employment. This can result in economic growth.

• Economic Recession: When withdrawals exceed injections, less money circulates,

reducing demand, production, and employment. This can lead to economic
recession.

Withdrawals > Injections Withdrawals < Injections

Fall in National Income (GDP) Increase in National Income

Rise in Unemployment Lower Unemployment

The economy could move to a recession Inflationary pressure due to higher Aggregate
demand

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The multiplier effect amplifies the impact of changes in injections or withdrawals. For
example, an increase in government spending can lead to a more significant overall
increase in economic activity, while a reduction in spending can have a compounded
negative effect, exacerbating recession. The multiplier effect explains how a small change
in spending can lead to a bigger overall impact on the economy.

Imagine the government spends money on building a new road. The workers and
companies that get paid for this project will have more money to spend on things like
groceries, clothes, or entertainment. The businesses they spend their money at will then
have more money to pay their own employees and suppliers. These people, in turn, spend
their money on other goods and services. This process continues, with the initial spending
creating more and more economic activity.

So, even a small increase in spending can lead to a much larger increase in total economic
activity, helping the economy grow. Conversely, if spending decreases, the opposite
happens, and the economy can shrink more than expected. This chain reaction is the
essence of the multiplier effect.

Section B – Measures of Actual Income

Learning Outcomes:
1. Calculate the nominal GDP from national income data, using the formula for the
Expenditure approach.

2. Distinguish between nominal GDP and real GDP.

3. Evaluate the performance of economies across time and countries, by way of

the measure of per capita real GDP.

4. Calculate real GDP and/or per capita real GDP.

5. Discuss the limitations of the use of per capita real GDP in judging the
performance of economies.

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The Gross Domestic Product shows the value of final goods and services produced by
the factors of production in a country. So, it refers to the total output produced each year
by factors of production located in a particular country.

GDP is commonly used to gauge the economic performance of a country:

• Economic Growth - Changes in GDP over time indicate the growth rate of the
economy. A rising GDP signifies economic growth, while a declining GDP indicates
economic recession.

• Standard of Living – GDP per capita (GDP divided by the population) is used to
comparing living standards across different countries.

• Policy-Making – Governments and Monetary Authorities use GDP figures to set

the appropriate fiscal or monetary policies.

Adjustments to GDP figures

1. Nominal GDP vs Real GDP

Nominal GDP is the total value of all goods and services produced in a country's economy
at current market prices within a specific period (usually a year), without adjusting for
inflation.

Real GDP, or Real Gross Domestic Product, measures the total economic output of a
country adjusted for price changes (inflation or deflation). This metric calculates the value
of all goods and services produced within a country in a specific year, using the prices of
a selected base year. By using constant prices, Real GDP provides a more accurate
reflection of an economy's size and how much it has grown in volume.

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Real GDP is calculated by using the formula:

REAL GDP = Nominal GDP X 100

GDP Deflator

The GDP deflator on the other hand, therefor is calculated by dividing the Nominal GDP
by the Real GDP and then multiplying the result by 100. This calculation provides an index
number (expressed as a percentage) that reflects the level of price inflation or deflation
between the base year and the year being measured. The formula is as follows:

GDP Deflator = Nominal GDP X 100

Real GDP

Difficulties with GDP figures

a. Difficulties in measuring GDP

I. Double Counting
o Important to measure the value added at each stage of production.
o If one counts the intermediate product with the final there would be
double counting.

II. Level of undeclared economic activity

o Goods and services produced and sold in an economy but not part

of the official National Figures

b. Difficulties in Interpreting GDP – important to take the following into consideration

I. Money GDP vs Real GDP
o When prices increase, the value of output in a country over a year
increase. But, people are not better off as they are not consuming
more goods and services.
o So, it is important to measure GDP at real prices – adjusted to take
into consideration inflation.

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II. GDP and population

o If GDP increases because of an increase in population, the standard
of living might fall.

o So, it is important to consider GDP per person.

III. Type of goods produced
o If GDP increases because of increase in production of military goods,

people are not better off.

IV. GDP and economic welfare

o A country could be facing a situation in which National Income
increases but general welfare falls.

o For example – pollution.

c. Difficulties in Comparing GDP – comparisons can be misleading due to:
I. Level of accuracy in measurement may differ between countries.
II. Discrepancy in distribution of income in different countries (standards of
living may differ)
III. Exchange rate might be unrealistic and not representing a good indication
of the relative domestic purchasing power of the two countries.

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Exercises
Exercise 1
The following information relates to the GDP figures of Country X in 2022:

• Consumption by Households (CH): €500 million

• Consumption by Non-Profit Institutions Serving Households (CNPISH): €50 million

• Government Consumption (CG): €200 million

• Investment (I): €150 million

• Exports (X): €120 million

• Imports (M): €100 million

Calculate:
a. Final Consumption Expenditure (FCE)
= 500 + 50 + 200 = EUR750

b. GDP
= 750 + 150 + 120 – 100 = EUR920

Exercise 2
The following information relates to the GDP figures of Country Y in 2022:

• Consumption by Households (CH): 600 million

• Consumption by Non-Profit Institutions Serving Households (CNPISH): 70 million

• Government Consumption (CG): €250 million

• Investment (I): €180 million

• Exports (X): €130 million

• Imports (M): €150 million

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Calculate:
a. Final Consumption Expenditure (FCE)

b. GDP

Exercise 3
During an economic recession in 2023, household consumption decreased while
government spending increased as a tool of fiscal policy. The data is as follows:

Description Year 2022 Year 2023

(€ millions) (€ millions)

Consumption by Households (CH) 800 750

Consumption by Non-Profit Institutions (CNPISH) 90 75

Government Consumption (CG) 300 450

Gross Investment (I) 200 160

Exports (X) 140 150

Imports (M) 130 160

Calculate for both years:

a. Final Consumption Expenditure (FCE)
2022 = 800 + 90 +300 = 1,190. 2023: 750+75+450 =EUR1,275

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b. GDP
2022: 1,190+200+140-130 = EUR1,400.

2023: 1,275 +160+150-160 = EUR1,425

c. Analyse the impact of the economic recession and government response on GDP.
Due to an economic recession, consumer confidence decreased. This is shown by the decrease in

Consumption of 800 to 750 by households, and 90 to 75 by NPISH. Inspite of also having a net withdrawal

of imports and exports, the government’s response of increasing its spending by 150,

resulted in an overall increase in GDP from 1,400 to 1,425.

Exercise 4
You are provided with the nominal GDP and the GDP deflator for three years. Calculate
the Real GDP for all years:

Year Nominal GDP (€ millions) GDP Deflator (Index)

2020 2,000 100
2021 2,100 102
2022 2,220 104

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Exercise 5
Calculate the per capita real GDP for each year listed in the table:

Year Real GDP (in millions of €) Population (in millions)

2017 2,000 40

2018 2,059 41

2019 2,135 42

Exercise 6

Calculate real GDP and per capita real GDP for each year.

Year Nominal GDP GDP Deflator Population

(in millions of €) (in millions)

2010 2,000 100 40

2011 2,100 105 41

2012 2,300 108 43

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Section C – The Economic Cycle

Learning Outcomes:

1. Identify the four phases of the economic cycle (Boom, Recession, Slump,
Recovery) through changes in real GDP.
2. Relate each of the four phases of the economic cycle to consumption,
investment, unemployment, the balance of trade, government tax
revenues and inflationary pressures.

3. Distinguish between the four phases of the economic cycle.

Growth does not happen in a regular fashion. There are periods of rapid growth followed
by periods of less rapid growth. In some circumstances, growth can fall to zero. In the
worst case, growth can be negative causing the economy of the country to shrink.

In the modern world we have become used to seeing steady growth punctuated by short
periods of zero or negative growth. A business cycle can be defined as a short-term
fluctuation of output around a long-term trend

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The economic cycle consists of four distinct phases characterised by changes in real GDP.
These phases are:

A. Slump

This is the lowest point in the business cycle where growth is at its lowest level. This point
is also known as the floor of the business cycle. At this point:

• Consumption: At its lowest.

• Investment: At its lowest.

• Unemployment: At its highest, reflecting the high number of job losses.

• Balance of Trade: Varied, can improve if imports remain low compared to exports.

• Government Tax Revenues: Remain low due to decreased economic activity.

• Inflationary Pressures: At its lowest.

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B. Recovery

This phase follows a slump, with the economy beginning to rebound. There is a gradual
increase in real GDP as businesses start to grow again, employment improves, and
consumer spending increases.

C. Boom

This is the highest point or ceiling of the business cycle. This is the point where the
economy overstretches itself. This phase is marked by an increase in economic activity.
Real GDP rises, reflecting growth in sectors such as manufacturing, services, and retail.
Economic confidence is high, leading to increased spending and investment. At this point:

• Consumption: High, as confidence leads to greater consumer spending.

• Investment: Businesses invest more in capital and expand their means of

production.

• Unemployment: Low, as companies hire more workers to meet demand.

• Balance of Trade: May deteriorate if imports increase faster than exports due to
high domestic demand.

• Government Tax Revenues: Increase due to higher earnings and consumption.

• Inflationary Pressures: Rise as demand outstrips supply, leading to higher prices.

D. Recession

The pace of growth slows as the economy moves towards a slump. During a recession,
the economy contracts, leading to a decrease in real GDP. This phase follows a boom and
is characterised by a slowdown in economic activity. Consumer spending and business
investment decrease, and economic uncertainty generally increases. The cycle then
continues again.

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