Economics - National Income - Notes - Economics, Study notes of Economics

Download Economics - National Income - Notes - Economics and more Study notes Economics in PDF only on Docsity! National Income Alfred Marshall defined national income (or National Dividend) as, “Labour and capital of a country acting on its natural resources, produce annually a certain ‘net’ aggregate of commodities, material and immaterial, including services of all kinds. The word ‘net’ means that from the gross value of the output depreciation of capital must be deducted” According to Pigou, national income is that part of the objective income of the community including, of course, income derived from abroad, which can be measured in money. Prof. Fisher based his idea of national income on consumption, rather than production. To him, National income refers solely to services received by ultimate consumers, whether from their material or human environment (Dewett 2005). The concept of national income thus has three interpretations: i) receipts total, ii) expenditure total, and iii) every expenditure is at the same time a receipt (expenditure by one is income to another). The Keynesian concept of national income lies between Gross National Product (G.N.P.) and Net National Product (N.N.P.). Thus, national income of a country may be expressed in terms of three measures:- (a) The sum of all incomes, in cash and kind, accruing to factors of production in a given time period, i.e., the total of income flows; (b) The sum of net outputs arising in several sectors of the nation’s production; and (c) The sum of consumers’ expenditure, government expenditure on goods and services and net expenditure on capital goods. National Income is presently defined as the aggregate factor income, arising from the production of goods and services by a nation’s economy during a specific period of time. The circular flow of income may be shown using a simple two sector model, consisting of only firms and households. Government sector and foreign sector are ignored here, to avoid further complications arising out of their inclusion. The economy is thus a closed economy, with no foreign trade or external sector. Further, the model is based on the following assumptions. All production takes place in the firms and all factors of production are owned by the households. There is full employment. Finally, all income are spent. Diagram-1 illustrates the real and money income flow in a two-sector model. The total of income flows, net outputs and final expenditures will be the same, but the significance of each arises out of the fact that they reflect the total operations of the nation’s economy at the level of three basic economic functions, namely, production, distribution and expenditure. 1.1.1 Concepts of national income There are five important concepts of national income. They are as follows: i) Gross National Product (G.N.P.): This is the basic social accounting measure of the total output or aggregate supply of goods and services. Gross National Product is defined as the total market value of all final goods and services produced in a year. The two aspects to be noted with respect to the gross national product are:- (a) it is a monetary measure of the market value of the output (i.e., goods and services) produced in a year. However, to know the accurate changes in physical output, the gross national product is adjusted for price changes by comparing it to a base year; and b) for the accurate computation of gross national product, the total goods and services produced in a specific year must be accounted only once. All finished goods go through different stages of production before being marketed. In the process, various forms of most of the goods are purchased and sold several times. This is likely to subject such goods to double accounting - once in its semi-finished form, and again as the final good. In order to avoid this problem, gross national product includes only the market values of the final goods, and ignores the transactions of intermediate goods. Final goods are those which are bought for final consumption and not for further processing or resale, whereas the intermediate goods are those which are purchased for further processing or resale. In GNP, the sales of only final goods are included and those of the intermediate goods are excluded, because the value of final good includes the value of intermediate goods as well. The calculation of G.N.P. also excludes non-productive transactions, which are pure financial transactions or transfer payments, such as old-age pensions or unemployment assistance, which are in the nature of grants, gifts, transactions relating to existing shares, or second-hand shares. 2) Net National Product (N.N.P.): The production process involves the use of capital, like equipment, machinery, etc., which experience wear and tear or depreciation in the value over time. Depreciation is known as the wear and tear of fixed capital or fall in its value, due to its constant or continuous use during the production process. Deducting payment for depreciation from the gross national product constitutes net national product. N.N.P. is the market value of all final goods and services, after deducting the depreciation charges. Hence, it is also known as national income at market prices. That is: - Net National Product or National Income at = Gross National Product + Depreciation Market Prices 3) National Income or National Income at Factor Cost (N.I.): National income at fixed cost differs from national income at market prices. National income at factor cost refers to the sum total of all incomes earned by the owners of all factors of production, resource suppliers for their contribution of land, labour, capital, and entrepreneurial ability, during a year. Generally, it is the national income at factor cost which is termed as ‘National Income’. The net national product is also known as national income at market prices. The difference between the two concepts arises from the fact that indirect taxes and subsidies result in market prices of output, which tend to be different from the factor incomes. For e.g., if one kg rice is sold at Rs. 20 which includes Rs. 2 of excise and sales tax, then the market price is Rs. 20 per kg., whereas its factors of production and distribution would receive only Rs. 18. A subsidy reduces the market price lower than the factor cost. For e.g., if rice is subsidized at the rate of Rs. 7 per kg and its sale price is Rs. 13, then the consumers would pay Rs. 13, whereas the factors of production and distribution would receive Rs. 20 per kg. Thus, the value of rice at factor cost would be equal to the market price plus the subsidies on it. Therefore, net national product minus indirect taxes plus subsidies is known as national income at factor cost. National Income or National Income = Net National Product – Indirect Taxes + Subsidies. at Factor Cost 4) Personal Income (P.I.): It is the sum total of all incomes actually received by all individuals or households during a particular year. National income is different from personal income, because some income earned are not actually received by households (e.g., social security contributions, corporate income taxes and undistributed corporate profits) and some incomes received are not currently earned (e.g., transfer payments, which include old-age pensions, unemployment relief, other relief payments, interest payment on the public debt, etc.). Therefore, while from national income is an indicator of income earned; personal income is an indicator of the income actually received. Hence, these three types of incomes which are earned but not received must be subtracted from national income, and incomes received but not currently earned must be added. Thus: Personal Income = National Income – Social Security Contributions – Corporate Income Taxes – Undistributed Corporate Profits + Transfer Payments. 5) Disposable Income (D.I.): Personal income minus the payment made to government in the form of personal taxes, like income tax, personal property taxes, etc., is known as disposable income. Thus, Disposable Income = Personal Income – Personal Taxes. This Disposable Income can be either used for consumption or saving. Therefore, Disposable Income = Consumption + Saving. 1.1.2 National income determination models borrowings. The C curve rises upwards to the right indicating that as income increases, consumption demand also increases As the 45° line also represents national income, the distance between the curve C and the 45° line represents saving, because a part of income after consumption is saved. Thus, National Income = Consumption + Saving or, Y = C + S, where, Y = national income, C = consumption, and S = saving. The diagram shows the distance between the national income line Y (i.e., 45° line ) and C ( propensity to consume) to be increasing, implying that as income increases, the amount saved also increases. In other words, savings and income are directly related. The propensity to consume remains stable or constant during the short period, because it (or the slope of curve C) depends upon the tastes and preferences of the people, which does not change in the short run. However, stable propensity to consume does not indicate no change in the consumption demand. It only implies that the consumption demand which increases with an increase in the income, does not change in the short period. Therefore, as consumption remains more or less stable during the short run, changes in the national income depend upon the changes in investment. Thus, investment which is the second component of aggregate demand is an important determinant of national income. Investment depends upon: (i) marginal efficiency of capital, and (ii) the rate of interest. Of them, interest rate is comparatively more stable. Therefore, the change in investment is mainly determined by the change in marginal efficiency of capital. The marginal efficiency of capital refers to the rate of return or expectation of profit from investment. In other words, the expected rate of profit is known as the marginal efficiency of capital. The marginal efficiency of capital in turn is determined by two factors, viz., a) the replacement cost of the capital goods, and b) the expectations of profit of the investors. Here, again, the expectations of profit are more important determinant of investment. This implies that if a country wishes to increase its national income or employment, then it should create an environment wherein the profit expectations of investors and businessmen are high. Any time in a country, given the rate of interest and marginal efficiency of capital, there will be a demand for investment goods. That is, entrepreneurs would invest some amount of capital. It is assumed that investment demand does not increase with an increase in income. On the other hand the demand for consumption goods increases with an increase in people’s income. This in turn raises the entrepreneur’s profit expectations, which increases the marginal efficiency of capital, and thus results in increased investment. This clearly indicates that the amount of investment is not directly determined by income. It is due to this reason that diagram - 2 does not show investment demand as an increasing function of income. Rather, it is shown combined with consumption demand as the C+I curve. By now it is well-known that at any given time in a country, the entrepreneurs invest a certain amount of capital. When investment demand is combined with the curve C, the aggregate demand curve C+1 is obtained, which represents both consumption and investment demand. The distance between the curve C and aggregate demand curve C+I represent investment (I). Given the propensity to consume, higher the investment, the higher would be the aggregate demand curve (C+I). The point at which the aggregate demand curve (C + I) intersects the aggregate supply curve, i.e., 45° angle line, the level of national income of a country would be determined at a given time. That is, when the aggregate demand and aggregate supply are in equilibrium, the national income of a country is determined at that point of time. In the diagram, the aggregate demand curve C+I intersects the aggregate supply curve (i.e., 45° angle line) at E. At this point, the equilibrium level of income is OY. When the income is either more or less than OY, then the aggregate demand C+I will be more or less, which in turn will affect the level of national income. When aggregate demand is lower, the entire output will not be sold out. This would result in a reduction in output, which will decrease the income. On the contrary, if income is greater than OY, then the total output or aggregate supply will be lower than the aggregate demand. This will lead to an increase in output, which in turn will result in increased national income. Thus, only when income is OY, aggregate demand and aggregate output are equal, and there will be no tendency for output or income to decrease or increase. This is the equilibrium level of income, which is determined by the interaction of aggregate demand and aggregate supply. At this level, the equilibrium level of employment is also determined, because national income, output and employment are interchangeable terms. 1.1.3 Equilibrium and full employment It is not necessary that the equilibrium level of national income achieved is also the point of full employment. The classicists totally opposed this view of Keynes. The classical economists claimed that the economy would always reach the state of full employment. Any deviation from full employment is strictly temporary and that there is a continuous tendency in the economic system to revert to the state of full employment. Keynes completely contradicted this view and proved both theoretically and in reality the possibility of under-employment equilibrium. In the diagram - 2, assume that OYF is the full employment level of national income. But given OY as the equilibrium level of income, it turns out to be lower than OYF, which is the full employment level. This indicates that the equilibrium level of income OY is at less than full employment. The equilibrium can be achieved at full employment income, only when the saving gap between income and consumption corresponding to full employment filled. At OYF level of full employment income, the saving is equal to FE’. When investment demand rises and covers this level of saving, the equilibrium level of income will be at full employment. However, there is no guarantee that the investment demand will be equal to saving at the full employment level of income. This is because saving and investment are done by different sets of people. Moreover, the factors that determine saving and investment are different from each other. Savings are made for various purposes, like education, construction of house, marriage, old age, future contingencies, etc. Investment is determined by the marginal efficiency of capital and rate of interest. Therefore, investment need not necessarily be equal to saving always at the full employment level of national income. When investment is less than saving, the equilibrium will be established at less than full employment. 1.1.4 Equilibrium income at equality of saving and investment that less money has been injected into the income stream and more has been withdrawn. As a result, the national income would decrease. On the other hand, when investment equals saving, it would imply that the amount of money injected has been withdrawn from the income stream. As a consequence, the national income would neither increase nor decrease, indicating an equilibrium condition. Thus, the equilibrium national income would be established at the level at which the intended investment equals the intended saving. Diagram – 3 shows the determination of national income by investment and saving. Y S I E I 0 Income Y X S Diagram 3: Determination of National Income by Saving and Investment In the diagram, the X-axis represents income and the Y-axis represents saving and investment. The SS curve shows intended saving and the II curve shows the intended investment or investment demand. The SS curve is upward sloping, indicating the intended saving to be rising at different levels of income. The II investment curve is parallel to the X-axis, due to the assumptions that investment does not change with income, and that entrepreneurs intend to invest only a certain amount of money in a particular year. The SS and II curves intersect each other at E, showing the equality between intended investment and saving at OY level of income. This indicates that OY is the equilibrium level of income. When the level of income is lower than OY, the amount of intended investment exceeds the intended saving, due to which the level of income would rise. On the other hand, when the level of income is greater than OY, the intended saving exceeds intended investment, as a result of which the level of income would fall. The decline in income would continue until it becomes equal to OY. At the OY level of income, there is neither a tendency for income to rise nor to fall, because at this level both the intended investment and intended saving are equal. Therefore, the equilibrium level of national income is determined by the equality in investment and saving at OY. In sum, the equilibrium level of national income would be determined under the fulfillment of the following two conditions: (i) Aggregate Demand = Aggregate Supply, and (ii) Intended Investment = Intended Saving. Thus, the equality between aggregate demand and aggregate supply and the equality between the intended investment and saving mean the same thing.