What is National Income; National Income is an aggregate based on the incomes earned in the production of those goods and services. Both Gross National Product and Net National Product are aggregates based on the output of goods and services. Let’s discuss in detail National Income Accounts.
THE NATIONAL INCOME ACCOUNTS
The economic well being of the people in a society is largely determined by the size, the distribution, and the regularity of the flow of goods and services from firms to households as described in the preceding diagrams. For this reason, measurements of these (and other) aspects of the flow are important materials in economic analysis, regardless of the type of economic system under study. These measurements are usually referred to as the National Income Accounts.
The problems involved in arriving at even rough estimates of the total flow and of various components of the total flow are extremely complex. In this section, we shall make no attempt to deal with the more complex conceptual problems that are involved in national income accounting. However, because of the importance attached to national income accounting in modern economics, we have included in a step-by-step picture of the construction and interpretation of the national accounts. In this section, we shall be concerned with the uses to which the accounts may be put, with the conceptual framework of national income accounting, with a description of the important elements in the accounts, and with the reliability and usefulness of the accounts for the purposes of economic policy-making.
IMPORTANT USES OF NATIONAL INCOME ACCOUNTS
Some of the more important uses of the income accounts are:
(1) They may be used in rough comparisons of the economic well being of a people at one period of time to their well being at other periods of time. For example, they provide us with rough answers to the question, “Are we better or worse off than we were twenty (or fifty) years ago?”
(2) They may be used in (very) rough comparisons of the economic welfare of the people in one country to the welfare of the peoples in other countries where such measurements are attempted. It Is the American level of living higher or lower than that of Canada? of Sweden? By how much? These are the kinds of questions to which the national accounts provide approximate answers.
(3) Measurements of the various components of the total flow provide valuable information on the structure of production, i.e., on what types of goods are produced and in what amounts, and on the relationships over time among the various components. How much of the total consists of nondurable consumer goods? of durable consumer goods? of durable producers’ goods? What is the relationship between changes in the output of consumer goods and changes in the output of the producer’s durables?
(4) The national income accounts provide valuable information on the phenomenon of alternating waves of prosperity and depression—on what happens during the course of such cycles, on why the wave-like movements take place, on what the business outlook is at any moment of time, on what might be done to smooth out the extremes of boom and bust. The adequacy of the currently available national income accounts for these purposes will be discussed in a later section.
The concept of national income. Any given national income figure is at best a statistical abstraction. It is a number, more or less arbitrary, certainly artificial, which is to stand for something real; but for what? Just what does a national income total measure? Let us begin an answer to this question with a description of the various meanings that may be attached to the single word, income.
Three types of income. Economics is concerned with the satisfaction of human wants. From this, it follows that a person’s income might be thought of as the flow of satisfactions received by that person over a given period of time. This type of income is referred to as psychic income and is clearly the type of income that is relevant to questions of human welfare. Unfortunately, there is no standard unit for measuring satisfactions, nor any convenient way of using such a unit if one existed.
An income measure that avoids the problem of measuring satisfactions, and is useful in its own right, is one that deals with the flow of goods and services received by an individual over a given period of time. This is referred to as real income. Unfortunately, even this flow of real goods and services cannot be measured directly because of the diverse character of the items that enter into the flow. How are pounds of pork chops to be added to gallons of milk, to bushels of wheat, to some number of haircuts? No meaningful sum could be obtained by adding a collection of such numbers.
An income measure that avoids this difficulty, as well as the difficulty of measuring satisfactions, is one that deals only with money, that is simply a count of the number of dollars received by a person over a given period of time. This is referred to as money income.
For a given person, and with some difficulty, money income measures can be turned into rough measures of real income; with even greater difficulty, real income measures can be turned into very
rough measures of psychic income. When it is the income of a nation which is involved, rather than that of a single person, these transformations become even more difficult and the resulting estimates even less reliable. However, money income and real income measures are useful in and of themselves.
The unit of measurement. The unit of measurement in national income accounting is the standard money unit of the country, e.g., the dollar in this country and the pound in Great Britain, the franc in France, the mark in Germany, etc. This is not the same as saying that all national income accounts deal with money income only. Rather it means that every item in whatever total is being measured, whether it be money income, real income, or something else, is assigned a dollar value, and the dollar values are then summed to arrive at the total. This is done, as was described above, because the money unit is practically the only standard unit in which each of the items can be expressed. The flow to be measured. The two-circuit wheel of wealth describes four separate flows:
(1) the flow of resource services to the firms,
(2) the flow of goods and services to the households,
(3) the flow of money to the firms in the form of payments for goods and services, and
(4) the flow of money to the households in the form of payments for resource services.
Only the first of these—the flow of resource services to the firms—is of little use in the problem at hand. The other three flows can all be used as rough approximations of the income of a society. In fact, all three are used at one time or another in modern national income accounting. The question of when each flow should be used in developing certain aggregates would take us into a more sophisticated analysis than is necessary or advisable at this point. It is sufficient to know that the national accounts may make use of (1) the total value of goods and services produced, or (2) the total expenditures for those goods and services, or (3) the total income payments to resource owners.
The time period. The magnitude of a continuous flow, whether of water or of goods and services, must be measured in terms of a rate, i.e., in terms of quantity per period of time. The flow of water through a main, for example, is often measured in terms of the number of gallons per hour passing through the main. The time period used in National Income Accounting is usually one year.
The use of any arbitrary time period creates difficulties (see Appendix A), and the one-year period is as convenient (or inconvenient) as any other. On other grounds, the one-year period has much to recommend it. For example, many of the data used in national income accounts are derived from individual accounts constructed with one year as the accounting period.
The important aggregates. Measurements of the flow of goods and services to an economy over a given time span give rise to several meaningful sums, rather than one. National Income, in the technical sense in which it will be described below, is but one of these sums (or aggregates). The most important aggregates developed in national income accounting are
(1) Gross National Product (GNP),
(2) Net National Product,
(3) National Income,
(4) Personal Income, and
(5) Disposable Personal Income.
Gross National Product. The total output of goods and services of the economy over a given period of time is called the Gross National Product for that period of time. This output is measured in money values, for the reasons already outlined. To make sure that each unit of a particular good or service is counted but once and to take account of the fact that not all goods attain the finished stage in the course of a given time period, the money value to be used in the total is assigned to the unit at the highest stage of production it has reached during the period. This avoids the error that would be involved, for example, in counting both the value of the flour and the value of the wheat from which that flour was made.
Net National Product. In the course of producing the goods and services that enter into Gross National Product, some “using up” of the capital goods of the economy is inevitable. When this depreciation of capital goods is subtracted from the Gross National Product, the remainder is the Net National Product of the economy. This, too, is expressed in terms of money values.
National Income. Both Gross National Product and Net National Product are aggregates based on the output of goods and services. National Income is an aggregate based on the incomes earned in the production of those goods and services. If the entire value of the Net National Product were passed on to the earned-income accounts, the money value of the Net National Product would be exactly equal to the money incomes earned in the production process, i.e., Net National Product would be exactly equal to National Income. In fact, not all of the money value of the goods and services produced can be credited to the earned-income account. Out of this money value, the firms who do the producing must pay various indirect taxes to various units of government. However, a money value can be assigned to these indirect taxes, and National Income can be derived directly from Net National Product. National Income is equal to Net National Product minus indirect business taxes.
Personal Income. Personal Income is the income actually received by households during the given period. If the firms were to pass on all of the earned income to the household, Personal Income would be exactly equal to National Income. However, firms may retain some of the earned income (or they may pay out more than has been earned). Also, the firms must pay taxes on their earnings (profit), and this reduces the total that is available for payment to households. Finally, households often receive payments from the various units of governments in the form of social security benefits, pensions, etc. These payments which do not represent payments of earned income are referred to as transfer payments. Thus Personal Income is equal to National Income minus retained profits and taxes on profits and plus transfer payments.
Disposable Personal Income. If there were no levies on the incomes received by households, the total amount of money which the households could dispose of as they wish would be equal to Personal Income. However, some part of Personal Income must always be used to pay the various personal taxes levied by the various units of government. Thus, Disposable Personal Income is equal to Personal Income minus personal taxes.
THE COMPONENTS OF TOTAL SPENDING
The Gross National Product is a measure of the total spending of all economic units for goods and services over the given period of time. This aggregate, total spending, is an important aggregate in economic analysis. For example, it is used extensively in the analysis of business cycles. Of equal importance are the various components of total spending. The components of total spending are identified in terms of the types of goods purchased and also in terms of the sources of total spending.
Types of goods purchased. In terms of types of goods purchased, total spending may be broken down into (1) spending for consumer goods and (2) spending for producers’ goods. Each of these types of spending may, in turn, be broken down into (1) spending for durable goods and (2) spending for nondurable goods. Sometimes government-produced goods and services are added to consumer goods and producers’ goods to yield a three-way classification.
Sources of spending. The total spending in an economy is the sum of the spending by four different source groups: consumers, private investors, units of government, and foreign buyers. Consumption spending by households is the largest single element in the spending total. Investment spending (the purchase of producers’ goods) by firms, while usually much smaller in total than consumption spending, is of great importance in economic analysis.
For example, the level of this type of spending is an important determinant of the rate of economic progress. A high level of investment spending means that a large number of buildings, machines, tools, etc., are being added to the productive equipment of the economy, which normally means a larger output of goods and services in the future. Investment spending is also one of the most volatile elements in total spending, i.e., it is subject to rapid swings from one level to another. For this reason, investment spending comes in for close scrutiny in the study of business cycles.
Government spending is assuming an ever-more important role in the total spending in modern economies. The reasons for this need not concern us here; it is important only to recognize that the various units of government represent an important source of total spending, both because of the volume of the spending and because of the directness with which it can be changed in response to public policy decisions.
Foreign spending is the fourth type of spending; it varies in importance from country to country. The purchase of English goods and services by buyers in other countries is a very important element in the total spending for the output of the English economy. While less important to our own economy, foreign spending is still a significant variable in the spending equation.
The major part of the National Income of a country is usually spent directly on consumer goods. That part of the National Income which is not so used, which is not spent on consumer goods, is described by the economist as savings. It follows from this that National Income is equal to consumption spending plus savings. If National Income is designated as Y, consumption spending as C, and savings as S, this relationship may be expressed in the equation, Y = C + S.
If we now view National Income in terms of the expenditures for goods and services and if we classify all expenditures as being made either for consumption goods or producer’s goods (investment), it follows that National Income is also equal to consumption spending plus investment spending. If investment spending is designated as I, this relationship may be expressed in the equation,
Y = C + I.
No involved algebraic manipulation is needed to show that, if
Y = C + S and Y = C + I,
then S must be equal to I. That is, savings is equal to investment. This relationship will come in for more intensive study in various later sections, particularly those dealing with business cycle analysis.
THE LIMITATIONS OF NATIONAL INCOME ACCOUNTS
Even the most sanguine of national income accountants would not claim perfect accuracy for his figures. The figures obtained are at best but rough approximations of the true figures. The question We have presented here a very simplified statement of these relationships. The equations can be expanded to take account of government expenditures and receipts and of exports and imports, but the basic equality between realized savings and investment remains. We shall develop the more complex patterns as the need for them as analytical tools arises, particularly in the discussion of business cycles and foreign trade, is not whether an error exists but whether it is of such magnitude as to destroy the usefulness of the accounts. No single answer can be given to this question; an error that would not be serious when the figures are being used for one purpose may be very serious when another purpose is involved.
In general, the figures obtained are more valid measures of money income than of real income, and more valid measures of real income than of psychic income. Changes in money income reflect changes in two types of variables, prices and quantities. Changes in real income require figures that reflect only changes in quantities. This necessitates the “deflating” of money income figures to eliminate the influence of price changes. However, this process opens the door to other uncertainties (see Appendix A) and the validity of the resulting estimates as measures of real income changes is always open to some question.
It is even more difficult to make valid inter-temporal or inter-country comparisons of psychic income. The precise relationship between real income and psychic income for even a given individual is so difficult to determine that the transformation of real income into psychic income measures is almost impossible.
Another important use for the national income accounts is in forecasting, particularly in forecasting the level of spending and employment at some date in the future. For this purpose not only must the various aggregates be relatively accurate, but also the movement over time of those aggregates and the relationships among them must be predictable. Results obtained so far in the use of national income accounts for purposes of forecasting would not seem to justify undue optimism. However, the continuing improvements in both data and techniques may warrant some optimism about the possibility of accurate economic forecasting in the future.