Author: Geoff Riley Last updated: Sunday 23 September, 2012
What is National Income?
National income measures the monetary value of the flow of output of goods and services produced in an economy over a period of time.
Measuring the level and rate of growth of national income (Y) is important for seeing:
The rate of economic growth
Changes to average living standards
Changes to the distribution of income
Gross Domestic Product
Gross domestic product (GDP) is the total value of output in an economy and is used to measure change in economic activity
GDP includes the output of foreign owned businesses that are located in a country following foreign direct investment. For example, the output produced at the Nissan car plant on Tyne and Wear and by 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:
National Output = National Expenditure (Aggregate Demand) = National Income
(i) The Expenditure Method - aggregate demand (AD)
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 – adding factor incomes
Here GDP is the sum of the incomes earned through the production of goods and services. This is:
Income from people in jobs and in self-employment
Profits of private sector businesses
Rent income from the ownership of land
Gross Domestic product (by factor incomes)
Only those incomes that are come from the production of goods and services are included in the calculation of GDP by the income approach. We exclude:
Transfer payments e.g. the state pension; income support for families on low incomes; the Jobseekers’ Allowance for the unemployed and welfare assistance such housing benefit.
Private transfers of money from one individual to another
Income not registered with the Inland Revenue or Customs and Excise. Every year, billions of pounds worth of activity is not declared to the tax authorities. This is known as the shadow economy or black economy. According to a World Bank report published in October 2010, the average size of the shadow economy (as a percentage of "official" gross domestic product) in Sub-Saharan Africa is 38.4 percent; in Europe and Central Asia (mostly transition countries), it is 36.5 percent, and in high-income OECD countries, it is 13.5 percent.
Published figures for GDP by factor incomes will be inaccurate because much activity is not officially recorded – including subsistence farming, barter transactions and the share economy mentioned above.
Value Added and Contributions to a Nation’s GDP
There are three main wealth-generating sectors of the economy – manufacturing, oil& gas, farming, forestry & fishing and a wide range of service-sector industries.
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 goods or services as a result of the production process
Value added = value of production - value of intermediate goods
Let us say that you buy a ham and mushroom pizza from Dominos at a price of £14.99. This is the final retail price and will count as consumption. The pizza has many ingredients at different stages of the supply chain – for example tomato growers, dough, mushroom farmers and also the value created by Dominos themselves as they put the pizza together and get it to the consumer.
Some products have a low value-added, for example those really cheap tee-shirts that you might find in a supermarket for little more than £5. These are low cost, high volume, low priced products.
Other goods and services are such that lots of value can be added as we move from sourcing the raw materials through to the final product. Examples include designer jewellery, perfumes, meals in expensive restaurants and sports cars. And also the increasingly lucrative computer games industry.
GDP and Purchasing Power Parity (PPP)
GDP for different countries is usually measured in a common currency – normally we use the US dollar. But there are two problems in using exchange rates to measure GDP
Exchange rates can be volatile from month to month and from year to year. For example a large depreciation in the value of the Argentinean peso against the US dollar might imply that Argentinean living standards have fallen even though their economy might actually be growing quite quickly
Exchange rates are more relevant to products that are traded between countries rather than non-traded products. Manufactured goods tend to sell for similar prices in most parts of the world – this is because international competition tends to reduce the differentials in prices for similar products. Non-traded service such as domestic cleaners, haircuts and academic tutors tend to have bigger differences in prices.
Calculations of GDP based on market exchange rates tend to over-estimate the cost of living in poorer developing countries. This is called the Balassa-Samuelson effect.
To make a PPP adjustment for comparing GDP we build a basket of comparable goods and services and look at the prices of that basket in different countries. Purchasing Power Parity is the exchange rate needed for say $100 to buy the same quantity of products in each country.
The Big Mac Index looks at the implied PPP exchange rates between countries and the actual exchange rates and uses this data to see if a currency is under or over-valued against the US dollar.
Big Mac prices in local currency
Big Mac prices in dollars
Implied PPP† of the dollar
Actual dollar exchange rate January 11th 2012
Under (-)/ over (+) valuation against the dollar, %
The data above is taken from Big Mac Index data for January 2012. The baseline data finds that a Big Mac costs an average of $4.20 in the United States and 3,700 South Korean won. If actual exchange rates were at their implied PPP levels, then the South Korean – US dollar exchange rate would be $1 = Won 882. In fact the Won is weaker than that against the dollar ($1 buys Won1159) which suggests that the Won is under-valued against the US dollar. So too – using the data above – is the Chinese Yuan and also the India Rupee whereas currencies such as the Brazilian Real and the Australian Dollar are over-valued on a PPP basis.
Data from the World Bank uses a huge amount of price data for different countries in order to calculate a PPP-adjusted level of GDP. But there are problems in making international comparisons across countries:
What types of product – rice seems to be homogeneous but it isn’t!
Differences in the quality of a good or service are reflected in price variations
Differences in consumption weights – for example consumption of cheese reflects household preferences between countries
Many goods and services are not bought and sold in markets and therefore do not have official prices – in many countries there is a large informal and/or subsistence sector
The quality of economic data varies across countries – many nations do not have sophisticated methods of collecting information
Despite these problems, PPP-adjusted real GDP will continue to be the key way in which we measure the total value of a nation’s output of goods and services, and to guide understanding of what is happening to average living standards between countries. The table shows GDP for the biggest economies in the world for 2011.
GDP by output – the distribution of GDP from different industries
The UK is an advanced economy where the majority of GDP comes from the service industries such as banking and finance, tourism, retailing, education and health and a vast range of other businesses services. In 2008 less than half of one per cent of our GDP came from the agricultural sector. Manufacturing accounted for less than 15 per cent of GDP and construction a further 6 per cent. In contrast, the service industries now contribute nearly three quarters of national income.
Manufacturing and service industries are not separate! For example the health of a car exporting business will have a direct bearing on demand, output, profits and jobs in many service businesses such as transportation, design, marketing and vehicle retailing. Equally service businesses such as online banking require plenty of physical inputs such as machinery and infrastructure to be successful.
The main service sector industries
Hotels and restaurants, and a range of services provided by local government
Transport, logistics, storage and communication
Business services and finance, motor trade, wholesale trades and retail trade
Land transport and air transport, post and telecommunications
Real estate activities, computer and related activities, Education, Health and social work
Sewage and refuse disposal
Recreational, cultural and sporting activities
The share of national output (GDP) for the UK economy
Notice in the chart above how there are long-term shifts in value added from the three main sectors – nearly 80% of national output in the UK comes from service industries. Industry (comprising manufacturing and construction) accounts for around a fifth. The pattern of GDP depends on many factors including the stage of a country’s economic development and the extent to which a nation has built up industries of competitive advantage in the world economy.
Contrast the UK data with that of Brazil shown in the next chart
Gross National Income (GNI)
Gross National Income (GNI) = the final value of income flowing to a country’s owned factors of production
GNI = GDP + Net property income from abroad (NPIA)
NPIA is the net balance of interest, profits and dividends (IPD) coming into a country from assets owned overseas minus profits and other income from foreign owned assets located within a country
GNI is boosted by inflows of remittance incomes from people living and working abroad
Measuring Real National Income
Real GDP measures the volume of output. An increase in real output means that AD has risen faster than the rate of inflation and therefore the economy is experiencing positive growth. Consider this example
The money value of a country’s GDP is calculated to be $4,000m in 2010. In 2011, the money value of GDP expands to $4,500m but during the year, inflation is 3% causing the general index of prices to rise from a 2010 base year value of 100 to 103 in 2011.
The real value of GDP in 2011 is calculated thus:
Real GDP = money value of GDP in 2011 x 100 / general price index in 2010
= £4,500 x 100/103 = $4,369 (measured at constant 2010 prices)
Note here that the real GDP data is expressed at constant priceswhich mean that we have made an inflation adjustment. Look for this in the data response questions in the exam.
Measuring Income per Head of Population
How much does each person earn on average? We use per capita measures to give us a guide to this. Income per capita is a way of measuring the standard of living for the inhabitants of a country.
Gross National Income per capita = Gross National Income / Total Population
Real per capita incomes, measured in US dollars, for a selection of countries
Heavily indebted poor countries (HIPC)
Hong Kong SAR, China
Central African Republic
High income: OECD
Congo, Dem. Rep.
The Growing Middle Class
A key feature of many faster-growing, lower-income countries is the emergence of a significant middle class of consumers. There is no single definition of the income level needed to be included in this category. Analysts at Invesco have produced the following data:
Middle class population in millions
Middle-class households are those with an annual income > US $ 5,000
Middle-class households are those with an annual income > US $ 10,000
The huge rise in the number of people calculated as having a middle-class income will be a major factor shaping growth and development in these countries in the years ahead. As per capita incomes rise, so too does the demand for consumer staple products, lifestyle products and financial services. Luxury product demand too will see abnormally high growth rates. All of this represents an enormous opportunity for multinationals who have built up global brands. For example:
40% of Apple’s revenues come from Asia Pacific and Japan
50% of the revenues for the Swatch group flow from Asian consumer markets
Nearly 30% of the revenues for Kraft Foods are generated in developing markets