National Income and Related Aggregates

The One Thing

National income accounting measures the value of current economic production, the incomes generated by that production, and expenditure on final goods and services. Its aggregates and methods are closely related, but GDP and national income are imperfect indicators of economic welfare.

Who and What

• Macroeconomics: The study of the economy as a whole, including national income, employment, general price levels, economic growth, and overall production.
• National Income: The net factor income earned by the normal residents of a country during an accounting year. It is equal to NNP at Factor Cost.
• Normal Resident: A person or institution whose economic interest is centered in a country and who normally lives or operates there, regardless of citizenship.
• Domestic Territory: The geographical territory administered by a government, including territorial waters, ships and aircraft operated by its residents, and certain embassies and consulates abroad.
• Final Goods: Goods purchased for final use and not for resale or further production during the accounting period.
• Intermediate Goods: Goods used as inputs in producing other goods and services during the same accounting period.
• Value Added: The increase in the value of a product at each stage of production; it equals the value of output minus the value of intermediate consumption.
• Gross Investment: Total expenditure on acquiring new capital goods and replacing worn-out capital goods.
• Depreciation: The fall in the value of fixed capital due to wear and tear, normal obsolescence, or expected accidental damage.
• Net Investment: Gross investment minus depreciation.
• Factor Income: Income earned by providing factors of production, including wages for labour, rent for land, interest for capital, and profit for entrepreneurship.
• Transfer Income: Income received without providing any current productive service, such as pensions, scholarships, and gifts.
• Net Factor Income from Abroad: Factor income received from abroad minus factor income paid to the rest of the world.
• GDP at Market Price: The market value of all final goods and services produced within the domestic territory of a country during an accounting year.
• GDP at Factor Cost: The value of domestic product measured by the payments made to factors of production.
• GNP at Market Price: The market value of final goods and services produced by the normal residents of a country, whether production occurs within the country or abroad.
• NDP at Market Price: GDP at market price after deducting depreciation.
• NNP at Market Price: GNP at market price after deducting depreciation.
• NNP at Factor Cost: National income; it is NNP at market price adjusted for net indirect taxes.
• Net Indirect Taxes: Indirect taxes minus subsidies.
• Market Price: The price paid by buyers for goods and services, including indirect taxes and excluding subsidies.
• Factor Cost: The amount received by factors of production for providing their services.
• Circular Flow of Income: The continuous movement of production, income, and expenditure between households, firms, government, financial institutions, and the foreign sector.
• Value-Added Method: A method of calculating national income by adding the net value added by all producing units in the economy.
• Income Method: A method of calculating national income by adding factor incomes earned by normal residents.
• Expenditure Method: A method of calculating national income by adding expenditure on final goods and services.
• Nominal GDP: GDP measured at current prices.
• Real GDP: GDP measured at constant prices, removing the effect of changes in the price level.
• GDP Deflator: An index showing the overall price change in domestically produced final goods and services.

GDP Deflator = (Nominal GDP ÷ Real GDP) × 100

• Per Capita Income: Average income per person, calculated by dividing national income by the population.
• Economic Welfare: The level of material well-being and quality of life enjoyed by people in an economy.

Causes and Consequences

• The circular flow links production, income, and expenditure. In a two-sector economy, households supply factors of production to firms and receive factor income. They then spend this income on goods and services produced by firms. Consequently, the basic identity is:

Production = Income = Expenditure. One person's expenditure therefore becomes another person's income.

• The distinction between domestic territory and normal residents determines the aggregate being measured. GDP focuses on production within the domestic territory, whereas GNP focuses on production by normal residents, whether it occurs domestically or abroad. Thus:

GNP at Market Price = GDP at Market Price + Net Factor Income from Abroad.

• Depreciation distinguishes gross from net aggregates. Gross measures include the value of capital used to replace worn-out capital, whereas net measures deduct depreciation. Therefore:

NDP at Market Price = GDP at Market Price − Depreciation NNP at Market Price = GNP at Market Price − Depreciation Net Investment = Gross Investment − Depreciation.

• Net indirect taxes distinguish market price from factor cost. Market price includes indirect taxes and excludes subsidies, while factor cost represents payments received by factors of production. Since:

Net Indirect Taxes = Indirect Taxes − Subsidies, market-price aggregates are converted to factor-cost aggregates by subtracting net indirect taxes: GDP at Factor Cost = GDP at Market Price − Net Indirect Taxes GNP at Factor Cost = GNP at Market Price − Net Indirect Taxes NDP at Factor Cost = NDP at Market Price − Net Indirect Taxes NNP at Factor Cost = NNP at Market Price − Net Indirect Taxes. Consequently: National Income = NNP at Factor Cost.

• The value-added method prevents double counting. It includes only final output or the value added at each stage of production.

Value Added = Value of Output − Intermediate Consumption. Net Value Added at Factor Cost = Gross Value Added at Market Price − Depreciation − Net Indirect Taxes.

• The income method measures the incomes generated by current production. It adds compensation of employees, operating surplus, mixed income of self-employed, and net factor income from abroad, with relevant adjustments where required:

National income = Compensation of employees + Operating surplus + Mixed income of self-employed + Net factor income from abroad. Operating surplus generally includes rent, royalty, interest, and profit.

• The expenditure method measures spending on final output. For GDP at market price:

GDPMP = Private Final Consumption Expenditure + Government Final Consumption Expenditure + Gross Domestic Capital Formation + Net Exports. Net Exports = Exports − Imports. Gross Domestic Capital Formation includes gross fixed capital formation, change in stocks, and valuables where applicable.

• The three measurement methods are conceptually equivalent. Total production generates total factor income and leads to total expenditure. When calculated correctly, the value-added, income, and expenditure methods should therefore produce the same national income result.

• The production boundary determines what is included. Market production and certain non-market production are generally included, but unpaid household services performed for one's own household are usually excluded because they do not enter measured market transactions.

• Previously produced goods and purely financial transactions are excluded from current production. Second-hand goods are excluded because they were counted when first produced; only brokerage or service charges related to their sale are included. Similarly, the purchase of shares and bonds is not current production, although commissions and brokerage services are included.

• Transfer payments are excluded because they do not reward current factor services. Pensions, scholarships, and gifts are transfer income rather than factor income and therefore are not included in national income.

• Intermediate goods must not be counted separately when final goods are already included. Excluding them from the expenditure total prevents the value of the same production from being counted more than once.

• Real GDP is more suitable than nominal GDP for comparisons over time. Nominal GDP is measured at current prices and may increase solely because prices have risen. Real GDP is measured at constant prices and removes this price effect. The GDP deflator provides an overall measure of price change.

• Per capita income provides an average measure of income. It is calculated as:

Per Capita Income = National Income ÷ Population. It can provide a better indication of average material living standards than total national income alone.

• Higher GDP or national income does not necessarily imply higher economic welfare. Welfare may fall despite rising GDP if income inequality, pollution, congestion, unemployment, or loss of leisure increases. National income may also fail to reflect non-market activities, informal production, product quality, distribution of income, environmental costs, health, education, security, and broader quality of life.

What Gets Asked

• Compare GDP and GNP, explaining the distinction between domestic territory and normal residents and the role of Net Factor Income from Abroad.
• Explain how gross and net aggregates differ through depreciation, using GDP, GNP, NDP, NNP, gross investment, and net investment.
• Convert between market price and factor cost using Net Indirect Taxes, and derive why NNP at Factor Cost equals National Income.
• Explain how the value-added, income, and expenditure methods measure the same economic activity, including the relevant equations and the avoidance of double counting.
• Identify why intermediate goods, second-hand goods, transfer payments, and purely financial transactions are excluded, while brokerage and other current services are included.
• Evaluate the usefulness and limitations of GDP, real GDP, nominal GDP, GDP per capita, and national income as measures of economic welfare.