Measuring National Income

Author: Geoff Riley  Last updated: Sunday 23 September, 2012

Introduction

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.

Country	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, %
Norway	Kroner 41	$6.79	9.77	6.04	62
Switzerland	SFr 6.50	$6.81	1.55	0.96	62
Sweden	SKr 41	$5.91	9.77	6.93	41
Brazil	Real 10.25	$5.68	2.44	1.81	35
Denmark	DK 31.5	$5.37	7.50	5.86	28
Australia	A$4.80	$4.94	1.14	0.97	18
Euro area	€ 3.49	$4.43	1.20	1.27	6
Japan	Yen 320	$4.16	76.24	76.9	-1
Britain	£2.49	$3.82	1.69§	1.54	-9
South Korea	Won 3,700	$3.19	882	1159	-24
Russia	Rouble 81.0	$2.55	19.30	31.8	-39
China	Yuan 15.4	$2.44	3.67	6.32	-42
South Africa	Rand 19.95	$2.45	4.75	8.13	-42
Malaysia	Ringgit 7.35	$2.34	1.75	3.14	-44
India	Rupee 84.0	$1.62	20.01	51.9	-61
United States	$4.20	$4.20	-	-	-

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 prices which 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

Country Name	2000	2005	2011	Country Name	2000	2005	2011
Qatar	64829	69512	77987	Heavily indebted poor countries (HIPC)	940	1051	1244
Luxembourg	61061	68320	68459	Low income	797	941	1190
Singapore	38063	45374	53591	Burkina Faso	853	1014	1149
Kuwait	38359	48783	47935	Nepal	903	954	1102
Norway	43975	47626	46982	Guinea-Bissau	1146	1017	1097
Hong Kong SAR, China	29785	35678	43844	Rwanda	661	840	1097
United States	39545	42516	42486	Haiti	1137	1023	1034
Canada	32447	35033	35716	Mozambique	501	670	861
Ireland	33424	38896	35640	Madagascar	904	869	853
Sweden	29145	32703	35048	Malawi	667	645	805
Australia	29663	32719	34548	Sierra Leone	424	647	769
Germany	30298	31115	34437	Central African Republic	766	672	716
High income: OECD	30419	32821	33726	Niger	597	610	642
High income	30004	32450	33533	Eritrea	576	596	516
Belgium	30398	32189	33127	Liberia	344	346	506
United Kingdom	29056	32738	32474	Congo, Dem. Rep.	260	277	329

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

	2010	2015 (Forecast)
China (i)	172	314
India (i)	186	366
Russia (ii)	91	123
Indonesia (i)	48	103
Brazil (ii)	48	69

• 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

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