Measuring National Income

We need information on how much spending, income and output is being created in an economy over a period of time. National income gives us this information.

Measuring national income To measure how much output, spending and income has been generated in a given time period we use national income accounts. These accounts measure three things: 1. Output: i.e. the total value of the output of goods and services produced in the UK. 2. Spending: i.e. the total amount of expenditure taking place in the economy. 3. Incomes: i.e. the total income generated through production of goods and services.

What is National Income? National income measures the money value of the flow of output of goods and services produced within an economy over a period of time. Measuring the level and rate of growth of national income (Y) is important to economists when they are considering: The rate of economic growth Changes over time to the average living standards of the population Changes over time to the distribution of income between different groups within the population (i.e. measuring the scale of income and wealth inequalities within society)

Consumer spending accounts for over two thirds of total spending. Consumer spending has been strong in recent years, a reflection of rising living standards and low unemployment, but this may now be coming to an end because of the mountain of household debt

Gross Domestic Product Gross Domestic Product (GDP) measures the value of output produced within the domestic boundaries of the UK over a given time period. An important point is that our GDP includes the output of foreign owned businesses that are located in the UK following foreign direct investment in the UK economy. The output of motor vehicles produced at the giant Nissan car plant on Tyne and Wear and by the many foreign owned restaurants and banks all contribute to the UK’s GDP.

There are three ways of calculating GDP - all of which should sum to the same amount since the following identity must hold true:

National Output = National Expenditure (Aggregate Demand) = National Income

Firstly we consider total spending on goods and services produced within the economy:

IB economics notes Measuring National Income [email protected] (i) The Expenditure Method of calculating GDP (aggregate demand)

This is the sum of spending on UK produced goods and services measured at current market prices. The full equation for GDP using this approach is GDP = C + I + G + (X-M) where C: Household spending I: Capital Investment spending G: Government spending X: Exports of Goods and Services M: Imports of Goods and Services

The Income Method of calculating GDP (the Sum of Factor Incomes)

Here GDP is the sum of the incomes earned through the production of goods and services. The main factor incomes are as follows: Income from people employment and in self-employment + Profits of private sector companies + Rent income from land = Gross Domestic product (by factor income)

It is important to recognise that only those incomes that are actually generated through the production of output of goods and services are included in the calculation of GDP by the income approach.

We exclude from the accounts the following items:  Transfer payments e.g. the state pension paid to retired people; income support paid to families on low incomes; the Jobseekers’ Allowance given to the unemployed and other forms of welfare assistance including child benefit and housing benefit.  Private transfers of money from one individual to another.  Income that is not registered with the Inland Revenue or Customs and Excise. Every year, billions of pounds worth of economic activity is not declared to the tax authorities. This is known as the shadow economy where goods and services are exchanged but the value of these transactions is hidden from the authorities and therefore does not show up in the official statistics!). It is impossible to be precise about the size of the shadow economy but some economists believe that between 8 – 15 per cent of national output and spending goes unrecorded by the official figures.

Output Method of calculating GDP – using the concept of value added This measure of GDP adds together the value of output produced by each of the productive sectors in the economy using the concept of value added.

Value added is the increase in the value of a product at each successive stage of the production process. We use this approach to avoid the problems of double-counting the value of intermediate inputs.

IB economics notes Measuring National Income [email protected] The table below shows indices of value added from various sectors of the economy in recent years. We can see from the data that manufacturing industry has seen barely any growth at all over the period from 2001- 2004 whereas distribution, hotels and catering together with business services and finance have been sectors enjoying strong increases in the volume of output. These figures illustrate a process of structural change, with a continued decline in manufacturing output and jobs relative to the rest of the economy. By far the largest share of total national output (GDP) comes from our service industries.

Index of Gross Value Added by selected industry for the UK Mining and Manufacturing Construction Distribution, Business services quarrying, inc oil & hotels, and and finance gas extraction catering; repairs 2001 weights in total GDP 28 172 57 159 249 (out of 1000) 2001 100 100 100 100 100 2002 100 97 104 105 102 2003 94 97 109 108 106 2004 87 98 113 113 111 We can see from the following chart how there have been divergences in the growth achieved by the manufacturing and the service sectors of the British economy. Indeed by the middle of 2006, the index of manufacturing output was below the level achieved at the start of 2000.

In contrast the service industries have enjoyed strong growth, leading to a continued process of structural change in the economy – away from traditional heavy industries towards service businesses.

GDP and GNP (Gross National Product) Gross National Product (GNP) measures the final value of output or expenditure by UK owned factors of production whether they are located in the UK or overseas. In contrast, Gross Domestic Product (GDP) is concerned only with the factor incomes generated within the geographical boundaries of the country. So, for example, the value of the output produced by Toyota and Deutsche Telecom in the UK counts towards our GDP but some of the profits made by overseas companies with production plants here in the UK are sent back to their country of origin – adding to their GNP.

IB economics notes Measuring National Income [email protected] GNP = GDP + Net property income from abroad (NPIA)

NPIA is the net balance of interest, profits and dividends (IPD) coming into the UK from our assets owned overseas matched against the flow of profits and other income from foreign owned assets located within the UK. In recent years there has been an increasing flow of direct investment into and out of the UK. Many foreign firms have set up production plants here whilst UK firms have expanded their operations overseas and become multinational organisations.

The figure for net property income for the UK is strongly positive meaning that our GNP is substantially above the figure for GDP in a normal year. For other countries who have been net recipients of overseas investment (a good example is Ireland) their GDP is higher than their GNP.

Measuring Real National Income When we want to measure growth in the economy we have to adjust for the effects of inflation. Real GDP measures the volume of output produced within the economy. An increase in real output means that AD has risen faster than the rate of inflation and therefore the economy is experiencing positive growth.

Income per capita Income per capita is a basic way of measuring the average standard of living for the inhabitants of a country. The table below is taken from the latest edition of the OECD World Factbook and measures income per head in a common currency for the year 2005, the data is adjusted for the effects of variations in living costs between countries.

GDP per capita $s GDP per capita $s Luxembourg 57 704 EU (established 15 countries) 28 741 United States 39 732 Germany 28 605 Norway 38 765 Italy 27 699 Ireland 35 767 Spain 25 582 Switzerland 33 678 Korea 20 907 United Kingdom 31 436 Czech Republic 18 467 Canada 31 395 Hungary 15 946 Australia 31 231 Slovak Republic 14 309 Sweden 30 361 Poland 12 647 Japan 29 664 Mexico 10 059 France 29 554 Turkey 7 687 Source: OECD World Economic Factbook, 2006 edition

IB economics notes Measuring National Income [email protected]