Economics Lecture Notes – Chapter 8

NATIONAL INCOME ACCOUNTING will be covered in the first and second weeks of term 1 in economics tuition.

Students can refer to Economics – A Singapore Perspective for the diagrams. The book is available in the major bookstores in Singapore.

1          INTRODUCTION

There are two main branches of economics: microeconomics and macroeconomics. Microeconomics deals with the analysis of individual parts of the economy. It concerns factors determining the behaviour of a consumer, the behaviour of a firm, the demand for a good, the supply of a good, the price of a good, the quantity of a good, the performance of a market, etc. Thus far, we have been dealing with microeconomics. Macroeconomics deals with the analysis of the whole economy. It concerns factors determining aggregate variables such as aggregate demand, aggregate supply, national output, national income, unemployment, inflation, the balance of payments, etc. As opposed to microeconomics which focuses on the individual parts of the economy, macroeconomics looks at the big picture of the economy. In order to understand macroeconomics, we first need to understand the concepts of national output and national income which are used for many purposes such as measuring the standard of living. This chapter provides an exposition of the concepts of national output and national income.

2          MEASUREMENT OF NATIONAL OUTPUT, NATIONAL INCOME AND NATIONAL EXPENDITURE

National output is the market value of all the final goods and services produced in the economy over a period of time. National income is the total income earned by the nation over a period of time. National expenditure is the total expenditure made on the final goods and services produced in the economy over a period of time. National output, national income and national expenditure are different economic variables. However, they have the same value.

When firms increase production which will lead to an increase in national output, they will employ more factor inputs from households and hence will pay them more factor income which will lead to an increase in national income. Therefore, an increase in national output will lead to an increase in national income. Furthermore, as the factors of production in the economy which include labour, land, capital and enterprise are owned by households, the increase in national income will be equal to the increase in national output.

Although it is easy to see why national income is equal to national output, it is less obvious why national expenditure is equal to national output. If all the final goods produced in the economy are purchased by households, firms, the government or foreigners, then it is obvious why national expenditure is equal to national output. However, even if some of the final goods produced in the economy are not purchased by households, firms, the government or foreigners, national expenditure is still equal to national output. This is because the final goods produced in the economy which are not purchased by households, firms, the government or foreigners are considered to be purchased by firms themselves. The value of these unsold goods, which is called stock in accounting, is known as inventory investment in economics. Inventory investment will be explained in greater detail in Chapter 9.

As national output, national income and national expenditure have the same value, there are three ways to measure national output: the output approach, the income approach and the expenditure approach.

Output Approach (Direct Approach)

Adding up the values of all the final goods and services produced in the economy and indirect taxes net of subsidies yields national output. Final goods and services are goods and services that are consumed by the end-users. They include consumer goods such as ice creams and cookies and capital goods such as factories and machinery. When measuring national output, the values of intermediate goods and services are excluded as they are already included in the values of final goods and services. Intermediate goods and services are goods and services that are used as inputs in the production of other goods and services. They include raw materials and semi-finished goods.

Income Approach (Indirect Approach)

Adding up the factor incomes (i.e. wages, rent, interest and profits) received by households from firms for the provision of factors of production and indirect taxes net of subsidies yields national income which is equal to national output.

Expenditure Approach (Indirect Approach)

Adding up the expenditures made on all the final goods and services produced in the economy yields national expenditure which is equal to national output. In an open economy, this involves adding up consumption expenditure, investment expenditure, government expenditure on goods and services and net exports. The expenditure approach will be explained in greater detail in Chapter 9.

Gross Domestic Product versus Gross National Product

Gross Domestic Product (GDP) is the market value of all the final goods and services produced in the economy over a period of time. Gross Domestic Product is commonly simply referred to as national output. In contrast, Gross National Product (GNP) is the market value of all the final goods and services produced by factors of production owned by the residents of the economy over a period of time. To put it somewhat differently, although Gross Domestic Product focuses on the location of factors of production, Gross National Product focuses on the ownership. Some of the goods and services produced in the economy are produced by factors of production owned by foreigners. When these foreigners earn wages, rent, interest and profit, they remit the income to their home countries. This income is called ‘factor income to abroad’. Similarly, some of the income earned by domestic residents comes from the ownership of factors of production located overseas. This income is called ‘factor income from abroad’. Gross National Product can be obtained by adding factor income from abroad and subtracting factor income to abroad from Gross Domestic Product.

Net National Product at Factor Cost

By equating national income to national output, I am effectively equating national income to Gross Domestic Product. However, it is important to note that some economists do not equate national income to Gross Domestic Product. Instead, they equate national income to Net National Product at factor cost. In the absence of indirect taxes and subsidies, market prices will be equal to the factor cost. In reality, the government imposes indirect taxes which make market prices higher than the factor cost, and gives subsidies which make market prices lower than the factor cost. When capital goods are used to produce goods and services, they wear out over time and this is called depreciation or capital consumption. Subtracting depreciation from gross investment yields net investment. Net National Product at factor cost can be obtained from Gross Domestic Product in three steps; add factor income from abroad and subtract factor income to abroad, subtract depreciation and subtract indirect taxes and add subsidies.

Disposable Income

Economists are interested to find out how consumption expenditure varies with income. For this purpose, instead of national income, disposable income is used. Disposable income is the income that households have available to spend or save after paying direct taxes and receiving transfer payments. To get disposable income from national income, we subtract undistributed corporate profits and direct taxes and add transfer payments.

Note:   The Singapore government measures national output using all the three approaches which include the output approach, the income approach and the expenditure approach. However, as the data are obtained from diverse sources, the three approaches yield slightly different results. To overcome the problem, a statistical discrepancy is included in the income approach and the expenditure approach to yield the same result as the output approach. 

Transfer payments are payments made by the government to the recipients not in exchange for any goods or services. They include social security benefits, unemployment benefits and interest payments on national debt. The Singapore government provides limited social security benefits and does not provide unemployment benefits. 

Students are not required to explain the derivation of Net National Product at factor cost from Gross Domestic Product.

National output will be discussed in economics tuition by the Principal Economics Tutor in greater detail.

3          THE BUSINESS CYCLE

The business cycle, or the trade cycle, refers to the periodic fluctuations of national output and hence national income around its long-term trend. It involves two phases: economic expansion and economic contraction. An economic expansion is a period of time during which national output and hence national income is rising. An economic contraction is a period of time during which national output and hence national income is falling.

The Business Cycle

In the above diagram, the upward sloping portions of the business cycle are economic expansions and the downward sloping portions are economic contractions. On average, an economic expansion is longer than an economic contraction. Therefore, national output and hence national income rises over time. Due to several factors such as globalisation, the business cycle is getting shorter. Although the duration between a trough and the next peak was between 10 and 15 years, it is now between 5 and 7 years. In other words, economic contraction is occurring more frequently. Nevertheless, expansion remains the normal state of the economy.

Note:   A recession is a fall in national output and hence national income for at least two consecutive quarters. This definition of recession, which is commonly known as a technical recession, is used in Singapore. However, the National Bureau of Economic Research (NBER) in the United States does not define a recession in terms of at least two consecutive quarters of fall in national output and hence national income. Rather, it defines a recession as a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.

4          NOMINAL NATIONAL OUTPUT AND REAL NATIONAL OUTPUT

Economists distinguish between two types of national output: nominal national output and real national output. Nominal national output is national output measured at current prices. Real national output is national output measured at base-year prices. Similarly, economists distinguish between two types of national income: nominal national income and real national income. Nominal national income is national income derived from the production of national output measured at current prices. Real national income is national income derived from the production of national output measured at base-year prices.

The size of an economy is measured by the amount of goods and services produced in the economy. Therefore, an economy grows when it produces a larger amount of goods and services. For the purpose of measuring economic growth, economists prefer the use of real national output to the use of nominal national output. As nominal national output is national output measured at current prices, an increase in nominal national output can be due to an increase in the amount of goods and services produced in the economy or a rise in the prices of goods and services. Therefore, when nominal national output rises, the economy may not necessarily be producing a larger amount of goods and services as the increase in nominal national output may be due to a rise in the prices of goods and services. However, as real national output is national output measured at base-year prices, an increase in real national output can only be due to an increase in the amount of goods and services produced in the economy as base-year prices do not change unless the government changes the base year. Therefore, when real national output rises, the economy is producing a larger amount of goods and services, which is known as economic growth.

Example: The Republic of Coconuts

Assume that

Output (2015) = 20 coconuts

Price (2015) = $3

Output (2010) = 15 coconuts

Price (2010) = $2

The base year is 2010

Therefore,

Nominal GDP (2015) = Output (2015) x Price (2015) = 20 x $3 = $60

Real GDP (2015) = Output (2015) x Price (2010) = 20 x $2 = $40

Nominal GDP (2010) = Output (2010) x Price (2010) = 15 x $2 = $30

Real GDP (2010) = Output (2010) x Price (2010) = 15 x $2 = $30

In the above example, the nominal GDP in 2015 was $60 and the nominal GDP in 2010 was $30. Therefore, the nominal GDP grew by 100% [($60 – $30)/$30 x 100%] from 2010 to 2015. However, much of the increase in the nominal GDP from 2010 to 2015 was due to an increase in the general price level. The real GDP in 2015 was $40 and the real GDP in 2010 was $30. Therefore, the real GDP grew by only 33% [($40 – $30)/$30 x 100%] from 2010 to 2015, which was lower than the 100% increase in the nominal GDP.

GDP Deflator

With nominal GDP and real GDP, we can measure the GDP deflator. The GDP deflator is an index of the average price of all the final goods and services produced in the economy over a period of time. It is used by economists to monitor the general price level. The GDP deflator measures the general price level in the current year relative to the general price level in the base year chosen by the government.

                         Nominal GDP (t)

GDP Deflator (t) = ————————— × 100

                          Real GDP (t)

From the above example, GDP deflator2015 = (Nominal GDP2015/Real GDP2015) x 100 = $60/$40 × 100 = 150, which means that the general price level rose by 50% from 2010 to 2015.

Inflation is a sustained rise in the general price level. The inflation rate is the percentage increase in the general price level. In theory, it can be calculated as the percentage increase in the GDP deflator.

                          GDP Deflator (t) – GDP Deflator (t–1)

Inflation Rate (t) = —————————————————— × 100

                          GDP Deflator (t–1)

 

Note:   The base year currently used to measure real GDP in Singapore is 2010. 

Although the inflation rate can be calculated as the percentage increase in the GDP deflator, it is calculated as the percentage increase in the consumer price index (CPI) in reality. The consumer price index (CPI) will be explained in greater detail in Chapter 11.

The GDP deflator will be discussed in economics tuition by the Principal Economics Tutor in greater detail.

5          NATIONAL INCOME AND THE STANDARD OF LIVING

Economists often use real national income to compare the standards of living over time (intertemporal comparison) and across space (international comparison). The standard of living refers to the material and non-material welfare of the people.

An increase in national income may lead to a rise in the standard of living. When firms increase production which will lead to an increase in national output, they will employ more factor inputs from households and hence will pay them more factor income which will lead to an increase in national income. Therefore, an increase in national income indicates an increase in national output. An increase in national output may lead to an increase in the amount of goods and services available for consumption. If this happens, the material standard of living will rise. Furthermore, when national output rises, the demand for labour in the economy will rise which will lead to a fall in unemployment. When this happens, the morale and self-confidence of the workers who were previously unemployed but have found a job may rise which may improve their mental health and this may lead to a rise in their non-material standards of living. In addition, the mental health of the workers who were previously employed and have remained employed may improve as they may experience a higher sense of job security and this may lead to a rise in their non-material standards of living.

However, due to several reasons, this is not necessarily true. Therefore, problems arise when national income is used to compare the standard of living over time and across space.

Intertemporal Comparison (Comparison Over Time)

An increase in national output may not lead to a rise in the standard of living because it may not lead to an increase in the amount of goods and services available for consumption due to several reasons.

First, the amount of goods and services available for consumption may not increase because the amount of non-marketed goods and services may decrease. The value of non-marketed goods and services is not included in national output. For example, when a baker bakes a pie, the value of the pie is included in national output. However, when a housewife bakes a pie, it is not. When unemployment falls due to an increase in national output, people will have less time to engage in the production of goods and services in the household economy which will lead to a decrease in the amount of non-marketed goods and services.

More examples:

In developing economies, many households engage in subsistence farming where they produce food to feed themselves. However, the value of food that these households produce is not included in national output. In this case, the omission of the value of non-marketed goods and services from national output understates the material standard of living as measured by national output. Over the last few decades, the national output of Singapore has increased dramatically partly due to an increase in the women labour force participation rate. Although the increase in the value of the goods and services that women produce in the market is included in the national output of Singapore, the decrease in the value of goods and services they produce at home is not subtracted. In this case, the omission of the value of non-marketed goods and services from national output overstates the material standard of living as measured by national output.

Second, the amount of goods and services available for consumption may not increase because the amount of undeclared goods and services in the underground economy may decrease. The value of undeclared goods and services in the underground economy is not included in national output. These goods and services are not declared because they may be illegal, such as drugs and prostitution, or for the purpose of tax evasion. For example, people smuggle tobacco and alcohol to evade tax. When unemployment falls due to an increase in national output, less people will engage in the production of goods and services in the underground economy which will lead to a decrease in the amount of undeclared goods and services.

Even if the amount of goods and services available for consumption increases, the standard of living may not rise due to several reasons.

First, the amount of goods and services available to domestic residents for consumption may not increase because the increase in national output may be due to an increase in exports. This is particularly true if the economy is highly dependent on external demand. If this happens, the increase in the amount of goods and services produced will lead to an increase in the amount of goods and services available to foreigners rather than domestic residents for consumption. Similarly, if the increase in national output is due to an increase in the amount of capital goods produced rather than an increase in the amount of consumer goods and services produced, the material standard of living may not rise.

Second, the amount of goods and services available to the average person for consumption may not increase because the population may have increased. In the event that the population has increased by a larger proportion, the amount of goods and services available to the average person for consumption will fall.

Third, an increase in national income may worsen income inequity. When national income rises, the incomes of high income individuals may rise by a larger proportion than those of low income individuals and this may be due to several reasons such as high income workers receiving larger wage raises than low income workers. If this happens, although low income individuals will be better off in absolute terms, the wider income gap will make them worse off in relative terms which will lead to a fall in their non-material standards of living.

Fourth, an increase in national output and hence production of goods and services may lead to an increase in the amount of negative externalities such as carbon emissions which will result in a more polluted environment and hence a fall in the non-material standard of living.

Fifth, an increase in national output and hence the demand for labour in the economy may result in people working longer hours which will cause them to have a smaller amount of leisure time and hence experience a fall in their non-material standards of living.

Contrary to what is discussed above, an increase in national output could mean a larger increase in the standard of living. First, the quality of goods and services produced may have improved. Second, the variety of goods and services produced may have increased.

International Comparison (Comparison Across Space)

If the national output of economy A is higher than that of economy B, the standard of living in economy A may not be higher because the amount of goods and services available for consumption may not be larger due to several reasons.

First, the amount of goods and services available for consumption in economy A may not be larger than that in economy B because the amount of non-marketed goods and services in economy A may be smaller. The value of non-marketed goods and services is not included in national output. For example, when a baker bakes a pie, the value of the pie is included in national output. However, when a housewife bakes a pie, it is not. The omission of the value of non-marketed goods and services from national output understates the material standard of living as measured by national output.

Second, the amount of goods and services available for consumption in economy A may not be larger than that in economy B because the amount of undeclared goods and services in the underground economy in economy A may be smaller. The value of undeclared goods and services in the underground economy is not included in national output. These goods and services are not declared because they may be illegal, such as drugs and prostitution, or for the purpose of tax evasion. For example, people smuggle tobacco and alcohol to evade tax. The omission of the value of undeclared goods and services in the underground economy from national output understates the material standard of living as measured by national output.

Even if the amount of goods and services available for consumption in economy A is larger than that in economy B, the standard of living in economy A may not be higher due to several reasons.

First, the amount of goods and services available to domestic residents for consumption in economy A may not be larger than that in economy B because the higher national output in economy A may be due to higher exports. This is particularly true if economy A is more dependent on external demand compared to economy B. If this happens, the larger amount of goods and services produced in economy A could mean a larger amount of goods and services available to foreigners rather than domestic residents for consumption relative to economy B. Similarly, if the higher national output of economy A is due to a larger amount of capital goods produced rather than a larger amount of consumer goods and services produced relative to economy B, the material standard of living in economy A may not be higher.

Second, the amount of goods and services available to the average person for consumption in economy A may not be larger than that in economy B because the population of economy A may be larger.

Third, the distribution of income in economy A may be less equitable than that in economy B. If this happens, the incomes of low income individuals in economy A may be lower than those of low income individuals in economy B which could mean a lower material standard of living in economy A.

Fourth, the amount of negative externalities such as carbon emissions which is produced in economy A may be larger than that is produced in economy B resulting in a more polluted environment in economy A and hence a lower non-material standard of living.

Fifth, the people in economy A may be working longer hours than those in economy B which means that the people in economy A may have a smaller amount of leisure time and hence a lower non-material standard of living.

Contrary to what is discussed above, a higher national output in economy A than in economy B could mean an even higher standard of living in economy A. First, the quality of goods and services produced in economy A may be higher than that in economy B. Second, the variety of goods and services produced in economy A may be greater than that in economy B.

Purchasing Power Parity

One problem with the use of national income to compare the standards of living in different economies is that the national income of an economy is measured in the local currency. In theory, this problem can be overcome by converting the national income of each economy in the local currency to a common currency such as the U.S. dollar using the market exchange rate. However, using the market exchange rate as a conversion factor will not take into account the differences in the costs of living in different economies. Although the World Bank does convert the national incomes of different economies in their local currencies to the U.S. dollar using the market exchange rate, the purpose is to compare the sizes of the economies rather than the standards of living.

The World Bank, however, also convert the national incomes of different economies in their local currencies to the U.S. dollar using the purchasing power parity (PPP) exchange rate with the purpose of comparing the standards of living. The purchasing power parity (PPP) exchange rate is the exchange rate which allows the amount of money that is required to purchase a basket of goods and services in one economy to purchase the same basket of goods and services in another economy after exchanging it into the currency of the other economy. Suppose that S$200 is required to purchase a basket of goods and services in Singapore. Further suppose that US$100 is required to purchase the same basket of goods and services in the United States. In this case, the purchasing power parity (PPP) exchange rate of the U.S. dollar against the Singapore dollar will be S$2/US$1. As the purchasing power parity (PPP) exchange rate takes into account the differences in the costs of living in different economies, it is a better conversion factor for the purpose of comparing the standards of living in different economies. Needless to say, we should also take into account the differences in the sizes of the population and a host of other factors. 

Note:   In addition to the factors that have been discussed in this section, in reality, the standard of living is affected by many other factors which include housing conditions, sanitary conditions, literary rate, life expectancy, etc. 

Gini coefficient is a measure of inequality of income distribution. It has a value between 0 and 1, where 0 corresponds to perfect equality (i.e. everyone has the same income) and 1 corresponds to perfect inequality (i.e. one person has all the income and everyone else has zero income). Therefore, a higher Gini coefficient indicates a wider income gap. The Gini coefficient in Singapore is above the internationally recognised alarming level of 0.4 and is one of the highest among developed countries. Even after taking into consideration taxes and transfer payments, the Gini coefficient in Singapore still remains above 0.4 while those of other developed countries all fall below 0.35.

Standard of living will be discussed in economics tuition by the Principal Economics Tutor in greater detail.

6          ALTERNATIVE MEASURES OF THE STANDARD OF LIVING

Due to the limitations of the use of national income as a measure of the standard of living, many economists have turned to alternative measures for this purpose. Among them, the Measurable Economic Welfare and the Human Development Index are the commonly used.

Measurable Economic Welfare (MEW)

Measurable Economic Welfare is a measure of the standard of living which is obtained by adding to national income factors which increase the standard of living such as leisure hours and subtracting factors which reduce the standard of living such as negative externalities. It is a better measure of the standard of living than national income as it takes into consideration a larger number of factors which affect the standard of living. A higher Measurable Economic Welfare indicates a higher standard of living and vice versa. Measurable Economic Welfare was developed in 1972 by two American economists, William Nordhaus and James Tobin, which they called it the Net Economic Welfare.

Human Development Index (HDI)

The Human Development Index is a composite index made up of three indices: an index for real Gross Domestic Product per capita in purchasing power parity dollars (PPP$), an index for life expectancy and an index for adult literacy and average years of schooling. Although it was developed as a measure of economic development, it is commonly used as a measure of the standard of living. It is a better measure of the standard of living than national income as it takes into consideration a larger number of factors which affect the standard of living. A higher Human Development Index indicates a higher standard of living and vice versa. The Human Development Index was developed in 1990 by Pakistani economist Mahbub ul Haq and Indian economist Amartya Sen. It has been published by United Nations since 1990.

Limitations

Although Measurable Economic Welfare and Human Development Index are better measures of the standard of living than national income, they are subject to several limitations. For example, it is difficult to measure the values of non-marketed ‘goods’ such as leisure hours and the values of non-marketed ‘bads’ such as negative externalities to obtain the Measurable Economic Welfare. Although Human Development Index takes into consideration a larger number of factors which affect the standard of living than national income, it omits several important factors such as housing conditions and the level of pollution.

Note:   MEW and HDI will be discussed in economics tuition by the Principal Economics Tutor in greater detail.

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