Meaning of National Income

National income refers to the total value of all final goods and services produced by the
residents of a country during a specific period, usually a year. It represents the total income
earned by the factors of production (land, labor, capital, and entrepreneurship) in an
economy. Essentially, it's a measure of a nation's economic activity and overall economic
well-being.

Key Concepts Explained

 Consumption of Fixed Capital: This refers to the decrease in the value of fixed
assets (like machinery and buildings) due to wear and tear, obsolescence, or
accidental damage during the process of production. It's also known as depreciation.
 Problem of Double Counting: This arises when the value of intermediate goods
(goods used in the production of other goods) is counted more than once while
calculating national income. To avoid this, we only consider the value of final goods
and services. For example, when calculating the value of a car, we include its final
selling price, not the separate values of the steel, tires, and engine used to manufacture
it.
 Net Factor Income from Abroad (NFIA): This is the difference between the income
earned by a country's residents from abroad for their factor services (like labor and
capital) and the income earned by foreigners within the country for their factor
services. If residents earn more abroad than foreigners earn domestically, NFIA is
positive, and vice versa.

Gross National Product (GNP), Net National Product (NNP), Gross Domestic
Product (GDP), and Net Domestic Product (NDP)

 Gross National Product (GNP): It is the total market value of all final goods and
services produced by the residents of a country, regardless of where the production
takes place, during a year. GNP=GDP+Net Factor Income from Abroad
 Net National Product (NNP): It is the GNP minus the consumption of fixed capital
(depreciation). NNP=GNP−Depreciation NNP represents the net output of a country
after accounting for the wear and tear of its capital stock.
 Gross Domestic Product (GDP): It is the total market value of all final goods and
services produced within the domestic territory of a country, regardless of who
produces them (residents or non-residents), during a year.
 Net Domestic Product (NDP): It is the GDP minus the consumption of fixed capital
(depreciation). NDP=GDP−Depreciation NDP provides a clearer picture of the net
value addition within a country's borders.

Measurement of National Income: Production Method (Value Added Method)

The production method measures national income by summing up the value added by each
producing unit in the economy during a year. Value added is the difference between the value
of output and the value of intermediate consumption.

Steps involved:
 1. Identify all producing units: Classify the economy into different sectors like
agriculture, industry, and services.
2. Estimate the value of output: Calculate the market value of goods and services
produced by each sector.
3. Estimate intermediate consumption: Determine the value of raw materials,
components, and services used in the production process by each sector.
4. Calculate value added: Subtract intermediate consumption from the value of output
for each sector. Value Added=Value of Output−Intermediate Consumption
5. Sum up the value added: Add the value added by all producing units across all
sectors to arrive at Gross Domestic Product at market prices.
6. Adjust to National Income: Convert GDP at market prices to Net National Product
at factor cost (National Income) by:
o Subtracting depreciation to get NDP at market prices.
o Adding Net Factor Income from Abroad to get NNP at market prices (GNP
minus depreciation).
o Subtracting Net Indirect Taxes (Indirect Taxes - Subsidies) to get NNP at
factor cost (National Income).

Measurement of National Income: Income Method

The income method measures national income by summing up all the factor incomes earned
by the factors of production (labor, capital, land, and entrepreneurship) in the form of wages,
interest, rent, and profit during a year.

Components of factor income:

1. Compensation of Employees: Wages, salaries, and other benefits paid to employees.

2. Operating Surplus: Income from property and entrepreneurship, which includes:
o Rent and Royalties: Income from the ownership of land and other natural
resources.
o Interest: Income from lending capital.
o Profit: Income of entrepreneurs, including dividends, retained earnings, and
corporate taxes.
3. Mixed Income of Self-Employed: Income of own-account workers and
unincorporated enterprises, which is a mix of wages, rent, interest, and profit.

Steps involved:

1. Classify factor incomes: Identify and categorize all factor incomes earned in the
economy.
2. Estimate each component: Calculate the total amount earned under each category of
factor income.
3. Sum up factor incomes: Add all the components of factor income to arrive at Net
Domestic Product at factor cost (NDP$_{FC}$). This is also known as Domestic
Income.
4. Adjust to National Income: Add Net Factor Income from Abroad to NDP$_{FC}$
to get Net National Product at factor cost (NNP$_{FC}$), which is the National
Income.

Measurement of National Income: Expenditure Method

The expenditure method measures national income by summing up all the final expenditures
incurred in the economy during a year. These expenditures are made by households,
businesses, and the government on final goods and services, as well as net exports.

Components of final expenditure:

1. Private Final Consumption Expenditure (C): Expenditure by households on goods

and services.
2. Government Final Consumption Expenditure (G): Expenditure by the government
on goods and services for collective consumption.
3. Gross Domestic Capital Formation (I): Expenditure on investment, including:
o Gross Fixed Capital Formation: Expenditure on new plant and machinery,
buildings, etc.
o Inventory Investment: Change in the stock of raw materials, semi-finished
goods, and finished goods.
4. Net Exports (NX): Difference between exports (X) and imports (M).
NX=Exports (X)−Imports (M)

Steps involved:

1. Identify final expenditures: Categorize all final expenditures in the economy.

2. Estimate each component: Calculate the total amount spent under each category.
3. Sum up final expenditures: Add all the components of final expenditure to arrive at
Gross Domestic Product at market prices (GDP$_{MP}$). GDPMP=C+G+I+NX
4. Adjust to National Income: Convert GDP$_{MP}$ to Net National Product at factor
cost (National Income) by:
o Subtracting depreciation to get NDP$_{MP}$.
o Adding Net Factor Income from Abroad to get GNP$_{MP}$.
o Subtracting depreciation from GNP$_{MP}$ to get NNP$_{MP}$.
o Subtracting Net Indirect Taxes (Indirect Taxes - Subsidies) to get NNP at
factor cost (National Income).

Problems Encountered in Estimating National Income

Estimating national income accurately is a complex task and faces several challenges:

1. Conceptual Problems:
o Defining "National": Difficulty in clearly defining who are the "residents" of
a country, especially with increasing globalization.
o Treatment of Unpaid Services: Whether to include the value of unpaid work
(e.g., housework) in national income.
o Valuation of Goods and Services: Difficulty in valuing non-market goods
and services (e.g., government services).
o Transfer Payments: Whether to include transfer payments (e.g., pensions,
unemployment benefits) as they don't represent value addition.
2. Statistical Problems:
o Lack of Reliable Data: In many developing countries, there is a lack of
comprehensive and reliable statistical data.
 o Problem of Double Counting: Difficulty in distinguishing between final and
intermediate goods.
o Unorganized Sector: A large unorganized sector makes data collection
challenging.
o Illegal Activities: Income from illegal activities (e.g., smuggling) is usually
not included.
o Price Fluctuations: Changes in prices can distort the real growth of national
income.
o Choice of Base Year: The choice of the base year for calculating real income
can affect the results.

Real GNP and Nominal GNP, GNP Deflator

 Nominal GNP: It is the value of final goods and services produced in a country
during a year, measured at current market prices. Changes in nominal GNP reflect
both changes in the quantity of goods and services produced and changes in their
prices.
 Real GNP: It is the value of final goods and services produced in a country during a
year, measured at constant prices of a chosen base year. Real GNP reflects only the
changes in the quantity of goods and services produced, as the effect of price changes
is eliminated.
 GNP Deflator: It is a measure of the average change in prices of all goods and
services that are included in GNP. It is the ratio of nominal GNP to real GNP,
multiplied by 100. GNP Deflator=Real GNPNominal GNP×100 The GNP deflator
can be used to convert nominal GNP into real GNP and to measure inflation in the
economy.

GDP Gap, Actual GDP, and Potential GDP

 Potential GDP: It represents the maximum level of output an economy can produce
when all its resources (labor, capital, land) are fully and efficiently employed. It's the
level of GDP that the economy could achieve under conditions of full employment.
 Actual GDP: It is the actual value of goods and services produced in an economy
during a given period. It can be above, below, or equal to potential GDP.
 GDP Gap: It is the difference between potential GDP and actual GDP.
GDP Gap=Potential GDP−Actual GDP
o Recessionary Gap (Negative GDP Gap): Occurs when actual GDP is less
than potential GDP, indicating underutilization of resources and
unemployment.
o Inflationary Gap (Positive GDP Gap): Occurs when actual GDP is greater
than potential GDP, indicating that the economy is operating beyond its
sustainable capacity, potentially leading to inflation.

Keynes' Psychological Law of Consumption

Keynes' Psychological Law of Consumption states that as income increases, consumption

expenditure also increases, but by a smaller proportion than the increase in income. In other
words, the marginal propensity to consume (MPC) is positive but less than one. People tend
to save a portion of their additional income.
Importance in Income Determination:

 Explains the possibility of underemployment equilibrium: If people save a large

portion of their income and aggregate demand (which includes consumption) is
insufficient, the economy can get stuck at a level of output below full employment.
 Forms the basis of the multiplier: The law implies that an initial increase in
investment or government spending will lead to a multiple increase in national income
because the induced consumption expenditure will keep the economic activity going.

Consumption Function, Autonomous Consumption, and Induced

Consumption

 Consumption Function: It shows the relationship between the level of consumption

expenditure and the level of disposable income (income after taxes). A simple linear
consumption function is often represented as: C=Cˉ+cYd Where:
o C = Total consumption expenditure
o Cˉ = Autonomous consumption
o c = Marginal propensity to consume (MPC)
o Yd = Disposable income
 Relationship between Consumption Expenditure and Personal Disposable
Income: The consumption function shows a direct and positive relationship. As
disposable income increases, consumption expenditure also increases.
 Autonomous Consumption (Cˉ): This is the level of consumption expenditure that
occurs even when disposable income is zero. It represents the basic consumption
needs that are met through borrowing or past savings. It is independent of the level of
income.
 Induced Consumption (cYd): This is the part of consumption expenditure that
changes with the level of disposable income. It is directly influenced by income and is
determined by the marginal propensity to consume (MPC).

Propensity to Consume, APC, MPC, and the Relationship between MPC and
k (Multiplier)

 Propensity to Consume: It refers to the proportion of income that households tend to

spend on consumption of goods and services.
 Average Propensity to Consume (APC): It is the ratio of total consumption
expenditure to total income (Y). APC=YC APC indicates the average percentage of
income spent on consumption.
 Marginal Propensity to Consume (MPC): It is the change in consumption
expenditure due to a one-unit change in income. MPC=ΔYΔC MPC indicates the
fraction of an additional rupee of income that is spent on consumption.
 Relationship between MPC and k (Multiplier): The multiplier (k) shows the extent
to which a change in autonomous expenditure (like investment or government
spending) leads to a change in national income. The simple income multiplier is
inversely related to the marginal propensity to save (MPS), which is (1 - MPC).
k=1−MPC1=MPS1 A higher MPC means a lower MPS, which results in a larger
multiplier effect. This is because if people spend a larger fraction of their additional
income, it leads to further increases in income and expenditure in the economy.
Propensity to Save, APS, and MPS

 Propensity to Save: It refers to the proportion of income that households tend to

save.
 Average Propensity to Save (APS): It is the ratio of total saving (S) to total income
(Y). APS=YS APS indicates the average percentage of income saved.
 Marginal Propensity to Save (MPS): It is the change in saving due to a one-unit
change in income. MPS=ΔYΔS MPS indicates the fraction of an additional rupee of
income that is saved.
 Relationship between APC and APS: Since income is either consumed or saved, the
sum of APC and APS is always equal to one. APC+APS=YC+YS=YC+S=YY=1
 Relationship between MPC and MPS: Similarly, the change in income is either
spent or saved, so the sum of MPC and MPS is always equal to one.
MPC+MPS=ΔYΔC+ΔYΔS=ΔYΔC+ΔS=ΔYΔY=1

Investment, Induced Investment, and Autonomous Investment

 Investment: In economics, investment refers to the expenditure on capital goods (like

machinery, equipment, and buildings) that are used for future production. It adds to
the capital stock of the economy.
 Induced Investment: This is investment that is undertaken primarily due to changes
in the level of income and demand in the economy. Higher income and expected
higher demand for goods and services tend to induce more investment by businesses
to expand capacity. Induced investment is positively related to the level of income.
 Autonomous Investment: This is investment that is independent of the level of
income. It is influenced by factors like technological innovations, population growth,
government policies, and expectations about future profitability that are not directly
tied to the current level of income. Autonomous investment is often considered
constant in simple macroeconomic models.

Marginal Efficiency of Capital (MEC) and its Role in Investment Decisions

 Marginal Efficiency of Capital (MEC): It is the expected rate of return from an

additional unit of a capital asset over its lifetime, discounted to its present value. In
simpler terms, it's the profitability of a new investment project.

How MEC helps in deciding the volume of investment:

Businesses will undertake investment projects as long as the expected rate of return (MEC) is
greater than or equal to the market rate of interest (r). The MEC schedule shows the inverse
relationship between the rate of return and the amount of investment. As more investment is
undertaken, the expected rate of return on further investment projects tends to decline due to
factors like diminishing returns and increased supply of capital goods. The equilibrium level
of investment is determined where MEC equals the market rate of interest.

Planned Saving vs. Planned Investment and Actual Saving vs. Actual
Investment
  Planned Saving and Planned Investment: These refer to the intended or desired
levels of saving and investment by households and firms, respectively, at different
levels of income. In a dynamic economy, planned saving and planned investment may
not always be equal. Discrepancies between them lead to changes in inventory levels,
which act as a signal for producers to adjust their output, eventually leading the
economy towards equilibrium.
 Actual Saving and Actual Investment: These are the realized or ex-post values of
saving and investment. In national income accounting, actual saving is always equal
to actual investment. This is an accounting identity because any unsold output is
considered as inventory investment, ensuring that total output (which equals total
income) is either consumed or invested. Y=C+I (from expenditure side)
Y=C+S (from income side) Therefore, C+I=C+S, which implies I=S (actual
investment equals actual saving).

The statement "planned saving may not be equal to planned investment but actual saving is
always equal to actual investment" highlights the difference between intended actions and
realized outcomes in the economy.

Equilibrium Level of National Income: Aggregate Demand (AD) = Aggregate

Supply (AS) and Saving (S) = Investment (I)

At the equilibrium level of national income in a simple two-sector economy (households and
firms), the total planned expenditure (Aggregate Demand) must be equal to

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Notes on What Is National Income - Unacademy

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FULL SOLUTION

Okay, let's continue and complete the explanations for the remaining questions.

Equilibrium Level of National Income: Aggregate Demand (AD) = Aggregate

Supply (AS) and Saving (S) = Investment (I)

At the equilibrium level of national income in a simple two-sector economy (households and
firms), the total planned expenditure (Aggregate Demand) must be equal to the total planned
output (Aggregate Supply). In this simplified model:

 Aggregate Demand (AD) = Planned Consumption (C) + Planned Investment (I)

 Aggregate Supply (AS) = National Income (Y)

Equilibrium occurs when: AD=AS C+I=Y

Since any income (Y) is either consumed (C) or saved (S), we have: Y=C+S

Substituting this into the equilibrium condition: C+I=C+S Subtracting C from both sides, we
get the alternative equilibrium condition: I=S

Therefore, in a two-sector economy, the equilibrium level of national income is established

where planned aggregate demand equals planned aggregate supply, which is equivalent to the
point where planned investment equals planned saving. If planned investment is greater than
planned saving, there will be unintended inventory depletion, encouraging firms to increase
production and income. Conversely, if planned saving is greater than planned investment,
there will be unintended inventory accumulation, leading firms to decrease production and
income until equilibrium is restored.

Components of a Two-Sector Economy and Equilibrium

A two-sector economy consists of:

1. Households: They are the consumers of goods and services and the owners of the
factors of production (labor and capital). They receive income in the form of wages,
interest, rent, and profit, and they spend it on consumption and saving.
2. Firms: They are the producers of goods and services. They hire factors of production
from households and make investments in capital goods.
Equilibrium in a two-sector economy is achieved when planned aggregate expenditure equals
the aggregate output. This can be represented by the intersection of the aggregate demand
curve (C + I) and the aggregate supply curve (which is a 45-degree line representing Y =
AS). At this point, the desired spending in the economy is exactly equal to the total value of
goods and services produced, and there is no tendency for income or output to change. As
discussed earlier, this equilibrium also corresponds to the point where planned saving equals
planned investment.

Components of a Three-Sector Economy and Equilibrium of Real GDP

A three-sector economy includes households, firms, and the government. The additional
component is the government sector, which plays a role through taxation and government
expenditure.

Components of Aggregate Demand in a Three-Sector Economy:

 Consumption Expenditure (C): Spending by households.

 Investment Expenditure (I): Spending by firms on capital goods.
 Government Expenditure (G): Spending by the government on goods and services
(e.g., infrastructure, defense, education).

Aggregate Demand (AD) in a three-sector economy is: AD=C+I+G

Equilibrium of Real GDP in a Three-Sector Economy:

Equilibrium occurs when planned aggregate demand equals aggregate supply (national
income, Y): Y=AD=C+I+G

In this context, the saving-investment equality is modified to include government saving

(which can be positive as a budget surplus or negative as a budget deficit).

National Income (Y) is now either consumed (C), saved by households (S), or goes to the
government as net taxes (T = Taxes - Transfers). Y=C+S+T

At equilibrium, Y=C+I+G, so: C+S+T=C+I+G S+T=I+G S−I=G−T

This shows that at equilibrium, the excess of saving over investment by the private sector (S -
I) must be equal to the government budget deficit (G - T), or equivalently, private saving plus
net taxes must equal planned investment plus government expenditure.

Net Export Function Relating to a Four-Sector Economy

A four-sector economy includes households, firms, the government, and the foreign sector.
The interaction with the foreign sector is captured through exports and imports.

 Exports (X): Goods and services produced domestically and sold to the rest of the
world. Exports add to the aggregate demand for domestically produced goods.
 Imports (M): Goods and services produced in the rest of the world and purchased by
domestic residents. Imports represent a leakage from the domestic expenditure stream.
Net Exports (NX) are the difference between exports and imports: NX=X−M

The net export function shows the relationship between net exports and the factors that
influence them, primarily the domestic income level (Y), foreign income level (Yf), the
exchange rate (E), and relative prices (P/Pf). A simple linear net export function can be
represented as: NX=Xˉ−mY Where:

 Xˉ represents autonomous exports (exports that are independent of domestic income).

 m is the marginal propensity to import, indicating the change in imports for a one-unit
change in domestic income. Imports tend to increase with domestic income.

A more comprehensive net export function would be: NX=f(Y,Yf,E,P,Pf)

 A higher domestic income (Y) tends to increase imports, thus decreasing net exports
(negative relationship).
 A higher foreign income (Yf) tends to increase exports, thus increasing net exports
(positive relationship).
 The exchange rate (E) affects the relative prices of domestic and foreign goods. For
example, a depreciation of the domestic currency makes domestic goods cheaper for
foreigners (increasing exports) and foreign goods more expensive for domestic
residents (decreasing imports), thus increasing net exports (complex relationship
depending on elasticities).
 Relative prices (P/Pf) also play a role. If domestic prices (P) rise relative to foreign
prices (Pf), exports may decrease and imports may increase, leading to a decrease in
net exports (negative relationship).

Factors that Cause a Shift in the Net Export Function

The net export function can shift due to changes in factors other than domestic income. These
include:

1. Changes in Foreign Income (Yf): An increase in foreign income typically leads to

an increase in demand for a country's exports, shifting the net export function upward
(more positive or less negative net exports at each income level). Conversely, a
decrease in foreign income would shift the function downward.
2. Changes in the Exchange Rate (E): A depreciation of the domestic currency
(making exports cheaper and imports more expensive) generally shifts the net export
function upward, assuming the Marshall-Lerner condition holds (elasticity of demand
for exports and imports is greater than one). An appreciation of the domestic currency
would have the opposite effect.
3. Changes in Relative Prices (P/Pf): If domestic prices increase relative to foreign
prices, the country's goods become less competitive internationally, leading to a
decrease in exports and an increase in imports, shifting the net export function
downward. A decrease in relative domestic prices would shift the function upward.
4. Changes in Tastes and Preferences: Shifts in global tastes towards a country's
products will increase exports, shifting the net export function upward. Changes in
domestic preferences towards foreign goods will increase imports, shifting the net
export function downward.
5. Trade Policies: Imposition of tariffs or quotas on imports by a country would
decrease imports and shift the net export function upward (at least for that country).
 Trade restrictions imposed by foreign countries on a nation's exports would shift its
net export function downward.

Fiscal Policy and the Balanced Budget Multiplier

Fiscal Policy refers to the use of government spending (G) and taxation (T) to influence the
level of aggregate demand and economic activity in a country. The main objectives of fiscal
policy are to stabilize the economy, maintain full employment, and promote economic
growth.

Balanced Budget Multiplier: This concept examines the effect on equilibrium national
income when the government simultaneously increases both government spending and taxes
by the same amount (ΔG=ΔT).

Let's analyze the impact on aggregate demand (AD=C+I+G) and equilibrium income
(Y=AD).

Assume a simple Keynesian model where consumption C=Cˉ+c(Y−T), investment I=Iˉ

(autonomous), and government spending is G.

Initial equilibrium: Y0=Cˉ+c(Y0−T0)+Iˉ+G0

Now, government spending and taxes both increase by ΔA, so ΔG=ΔT=ΔA. The new
equilibrium income Y1 is: Y1=Cˉ+c(Y1−(T0+ΔA))+Iˉ+(G0+ΔA) Y1=Cˉ+cY1−cT0
−cΔA+Iˉ+G0+ΔA

Subtracting the initial equilibrium equation from the new one: Y1−Y0=c(Y1−Y0)−cΔA+ΔA
ΔY=cΔY+(1−c)ΔA ΔY−cΔY=(1−c)ΔA ΔY(1−c)=(1−c)ΔA ΔY=ΔA

This result shows that when government spending and taxes increase by the same amount, the
equilibrium level of national income increases by exactly that amount. Therefore, the
balanced budget multiplier is equal to 1.

The intuition behind this is that an increase in government spending directly adds to
aggregate demand by ΔA. The increase in taxes reduces disposable income, leading to a
decrease in consumption by c×ΔA (where c is the MPC). The net effect on aggregate demand
is ΔA−cΔA=(1−c)ΔA. However, the direct increase in government spending has a full
multiplier effect.

Let's look at the change in income through the multiplier process more formally:

ΔY=k×ΔG+(−ck)×ΔT where k=1−c1 is the simple multiplier.

Given ΔG=ΔT=ΔA: ΔY=1−c1ΔA−1−ccΔA ΔY=1−c1−cΔA ΔY=1×ΔA=ΔA

Thus, the balanced budget multiplier is indeed 1. This implies that a simultaneous and equal
increase in government spending and taxation leads to an increase in national income equal to
the increase in government spending (and taxes). The expansionary effect of increased
government spending is partially offset by the contractionary effect of increased taxes (due to
reduced disposable income and hence consumption), but the direct impact of government
spending outweighs the indirect impact of taxes on consumption by a factor that results in a
net multiplier of one.

I hope this comprehensive explanation covers all your questions thoroughly! Let me know if
you have any further questions.