Module 6. National income

Lesson 26

26.1 Introduction

Two methods are commonly use to measures of National Product Goods and services flow and earning Flow. We can measure GDP in three entirely independent ways either as a flow of products or as a sum of earnings.

To demonstrate the different ways of measuring GDP, we begin by considering an oversimplified world in which there is no government, foreign trade, or investment or we can think in terms of closed economy. The product produces in an economy assume to be the only consumption goods, which are items that are purchased by households to satisfy their wants.

26.2 Flow-of-Product Approach

In the Flow-of-Product Approach, we include only final goods-goods ultimately bought and used by consumers. Households spend their incomes for these consumer goods, as in shown in the upper loop of Figure 6-1. Add together all the consumption rupees spent on these final goods and services, we will arrive at this simplified economy’s total GDP. Thus, in our simple economy, we can easily calculate national income or product as the same of the annual flow of final goods and services for all other final goods. The gross domestic product is defined as the total money value of the flow of final products produced by the nation. National accountants use market prices as weights in valuing different commodities because market prices reflect the relative economic value of diverse goods and services. That is, the relative economics prices of different goods reflect how much consumers value their last (or marginal) units of consumption of these goods. Each year the public consumes a wide variety of final goods and services such as apples, computer software, and blue jeans; services such as health care and haircuts etc.

26.3 Cost Approach

In the earning or cost approach, it flow all the costs of doing business; these costs include the wages paid to labour, the rents paid to land, the profit paid to capital, and so forth. But these business costs are also the earnings that households receive from firms. By measuring the annual flow of these earnings or incomes, statisticians will again arrive at the GDP.

Hence, a second way to calculate GDP is as the total of factor earning (wages, interest, rent and profits) that is the costs of producing society’s final products.

We have calculated GDP by the upper-loop flow-of –product approach and by the lower-loop earnings-flow approach. The surprise is that they are exactly the same.

We can see why the product and earnings approaches are identical by examining a simple barbershop economy. Say the barbers have no expenses other than labor. If they sell 10 haircuts at Rs. 8 each, GDP is Rs. 80.But the barbers’ earnings (in wages and profits) are also exactly Rs.80. Hence the GDP here is identical whether measured as flow of products (Rs.80 of haircuts) or as cost and income (Rs.80 of wages and profit).

In fact, the two approaches are identical because we have included “profit” in the lower loop along with other incomes. What exactly is profit? Profit is what remains from the sale of a product after you have paid the other factor costs-wages, interest and rents. It is the residual that adjusts automatically to make the lower loop’s costs or earnings exactly match the upper loop’s value of goods.

To sum up:

GDP, or gross domestic product, can be measured in two different ways

As the flow of final products-Product approach

(1) As the total costs or earnings of inputs producing output-Income approach

(2) Expenditure approach.

Because profit is a residual, both approaches will yield exactly the same total GDP.

In practice, economists draw on a wide array of sources, including draw on a wide array of sources, including surveys, income-tax returns, retail-sales statistics and employment data. The most important source of data is business accounts. An account for a firm or nation is a numerical record of all flows (outputs, costs, etc.) during a given period. We can show the relationship between business accounts and national accounts by constructing the accounts for an economy made up only of farms. The national accounts simply add together or aggregate the outputs and costs of the economy.

The nominal income refers to the actual amount which a person received in particular time of period may be in month or weekly which does not have the effect of inflation and which is fixed in any circumstances, for example if there is raise in the prices of the commodities it leads the prices to the inflation but there will be no effect on the nominal income holder as it is fixed, however in the real income scenario the inflation amount will affect the real income as it is to be deducted from the nominal income, hence

Real Income = Nominal income- Inflation,

Therefore we can say that real income is the good measure to know the actual purchasing power of the economy and good aggregate to calculate the national income.

26.4 Concept of Inflation and Price Index

The term "inflation" originally referred to increases in the amount of money in circulation, and some economists still use the word in this way. However, most economists today use the term "inflation" to refer to a rise in the price level. An increase in the money supply may be called monetary inflation, to distinguish it from rising prices, which may also for clarity be called 'price inflation'. Economists generally agree that in the long run, inflation is caused by increases in the money supply. However, in the short and medium term, inflation is largely dependent on supply and demand pressures in the economy.

Other economic concepts related to inflation include:

Deflation – a fall in the general price level

Disinflation – a decrease in the rate of inflation

Hyperinflation – an out-of-control inflationary spiral

Stagflation – a combination of inflation, slow economic growth and high unemployment and

Reflation – an attempt to raise the general level of prices to counteract deflationary pressures.

Since there are many possible measures of the price level, there are many possible measures of price inflation. Most frequently, the term "inflation" refers to a rise in a broad price index representing the overall price level for goods and services in the economy. The Consumer Price Index (CPI), the Personal Consumption Expenditures Price Index (PCEPI) and the GDP deflator are some examples of broad price indices. However, "inflation" may also be used to describe a rising price level within a narrower set of assets, goods or services within the economy, such as commodities (including food, fuel, metals), financial assets (such as stocks, bonds and real estate), services (such as entertainment and health care), or labour.
Last modified: Wednesday, 3 October 2012, 9:31 AM