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NATIONAL INCOME ACCOUNTING
National Income is the outcome or the end result of all economic activities. Economic
activities generate two kinds of flows (i) money flows- these are in exchange for services
of factors of production in the form of flows- these are in exchange for services of factors
of production in the form of wages, rent, interest and profits (i.e factor earnings) (ii)
Product flows, are flows of consumer goods and services and productive assets. All
human activities which create goods and services that can be valued at market price are
broadly the economic activities.
Macroeconomics deals with a number of large totals or aggregates, which are used to
conceptualize and measure key components of the economy. The most fundamental of
these is the total output of goods and services, conventionally referred to as the national
income. (Official data in most countries is now actually reported on a "domestic" rather
than a "national" basis. The distinction, which is unimportant for most purposes, relates
to the treatment of investment income received from non-residents and paid to nonresidents. "Domestic income" is that produced within a country by all producers
operating there, whether foreign or not. "National income" is that produced only by
"nationals" of that country, whether they are producing it there or elsewhere.)
There is nothing inconsistent in referring to total output as income. Although what is
earned as income can be measured separately from what is produced, the two aggregates
are necessarily the same in amount. Before going on to see why, note that in either case
such large totals can be expressed only in terms of money, not physical products as such.
It is impractical to try to measure output or income in real, physical terms, simply
because it is impossible to sum apples and oranges or any of the millions of goods and
services which are produced and received as income in a modern economy. Instead,
physical quantities must be converted to a common measure and the measure used for
this purpose is the national unit of account, the dollar, pound, or other currency.
The value of total output or income in an economy during some accounting period,
usually a year or quarter of a year, is a significant statistic. It is generally used as an
indicator of the economy’s performance. Because a larger output or income is equated
with a rise in the economic well being of a country’s population, a higher output or
income is considered desirable and a lower one undesirable. The economy’s overall
performance is tracked by the changing value of the total output or income statistic.
Similarly, comparisons of relative well-being among different countries are based on
these statistics and a host of political and social as well as economic implications flow
from their behaviour over time.
The Circular Flow
A modern economy can be simply modeled in the aggregate by thinking of it as
comprising two key sectors, households which consume produced goods and services and
which supply labour and other productive services to firms, which use the labour and
other productive services supplied by households to produce the goods and services the
households consume. Households supply the services of productive factors (land, labour,
capital, etc.) and the firms convert these inputs into produced goods and services which
return to the households. Owners of firms are, of course, also part of the household sector
where they function in their other capacity as consumers of goods and services.
The real flows of productive services and produced outputs have corresponding flows of
money payments associated with them. Firms pay out wages and salaries in return for
labour services, rents to owners of land and other natural resource inputs, and interest and
profits to suppliers of capital and entrepreneurial inputs. Householders consequently have
money income with which to pay for the produced goods and services that flow to them
from firms. Thus, there are money flows corresponding to the real flows, but they move,
of course, in the opposite direction.
Circular Flow of Income
Services of factors of Production
Goods and services
H/HOLDS
FIRMS
Spending
Incomes
Because the flows of payments for produced goods and services and payments for factor
inputs are continuous, aggregate income/output in this simple model could be measured
at any point, metering the flow anywhere in the circuit. If measured in terms of spending
on produced goods and services, it would be natural to call this a measure of total
spending or total expenditure. If measured in terms of outlays made for the services of
productive factor inputs, it would be total income (from the point of view of the owners
of those factor inputs). Obviously the two totals would have to be the same.
This is a greatly simplified model. One thing missing is the possibility of saving. If
households do not spend all their income on produced goods and services, but hold some
of it back as savings, every time income flows into the household sector the flow of
payments made to producers will diminish. This is a "leakage" of income/spending from
the system and the volume of the flow would diminish—the level of national income
would fall. But if there are savings, there could also be new investment. If businesses
borrowed income saved by households and used it to finance the building of new plant or
for other business purposes, it would be injected back into the income stream (in the form
of payments to workers and other factor owners who supplied the necessary real inputs
needed to produce the new capital). Banks and other financial intermediaries serve as the
nexus through which savings are converted into investment spending and returned to the
income stream.
In the simple economy above we can write the identity of output produced and output
sold as Y ≡ C+I. That is all output produced is either consumed or invested. The
corresponding identity for the disposition of personal income is that the income is
allocated on C (Consumption) and part is saved (S). This implies that Y ≡ C+S. It also
flows that C+I ≡ Y ≡ C + S. Subtracting C from both sides gives I ≡ Y - C ≡ S which
shows that saving is also income less consumption and also investment is identically
equal to saving.
If another complication, government, is added to the simple model, another potential for a
leakage of income from the system is introduced. Governments impose taxes (T) on
households (and firms) and this results in a diversion of income from the private sector to
government. This is another leakage and it too has a corresponding potential for injecting
such income back into the stream, this time in the form of government spending on
produced goods and services. Taxation reduces disposable income. Disposable income is
given by Yd ≡ Y-T and also Yd ≡ C+S. Thus C+S ≡ Yd ≡ Y-T
Finally, most real world economies are not closed loops. Instead they are "open" to the
rest of the world, with leakages from domestic income/expenditure flows in the form of
payments made for goods and services produced abroad ( imports, M) and injections of
income back into the domestic flows as a result of sales of goods by domestic firms to
consumers abroad (exports, X). As already seen, there can also be important flows of
savings and investment between one country and the rest of the world.
Circular Flow of Income
Services of factors of Production
Goods and services
H/HOLDS
FIRMS
Spending
Incomes
LEAKAGES/WITHDRAWALS
Savings
Taxation
Imports
INJECTIONS
In vestments
Government Expenditure
Exports
From the diagram Y = C + I + G + (X-M) = C + S + T
The important ideas to understand at this point are that national income or expenditure
can be thought of as a continuous flow which can be measured in different ways (
Product ≡ income ≡ expenditure on the product) and that this simple process is
complicated by the possibilities of leakages and injections arising from private saving and
investing; government taxation and spending; and foreign trade and capital movements.
THE NATIONAL ACCOUNTS
All the economies today measure the volume of aggregate income, usually defined as
Gross Domestic Product, in much the same way.
Gross Domestic Product (GDP)
Refers to the total monetary value of all goods and services produced within the
geographic boundaries of a nation during a given year. The word “domestic” implies that
only the income produced in that country is accounted for. The income that arises from
investments and possessions owned abroad is thus not included in the GDP estimates.
Calculation of GDP
-calculated simply by valuing the outputs of all “final” goods and services at “market”
prices ( i.e. actual prices at which they are bought and sold) and then adding the total.
N.B. The market value of all intermediate products- those used to produce the final
output is excluded from the calculation of GDP since the values of intermediate goods are
already implicitly included in the market prices of the final goods. “Gross” implies not all
output was available for private/public consumption and investment, part went to replace
or maintain worn out capital equipment.
Nominal and Real GDP
Two measures of GDP are given: nominal GDP (also called current dollar GDP) and real
(constant dollar) GDP. Nominal GDP measures the value of output at the prices
prevailing at the time of production, while real GDP measures the output produced in any
one period at the prices of some base year. The growth rate of the economy is usually
taken to be the rate at which real GDP is increasing.
Whatever their minor differences, all national accounting conventions follow the basic
pattern identified in the preceding discussion of the circular flow of income and
expenditure. There are always at least two main calculations, one which sums total
expenditures on goods and services produced, the other of total income received as a
result of producing those same goods and services. Because both are measures of the
same thing they must, by definition, yield the same total.
In national accounting in ex-post sense expenditure on production is always equal to
production and income. Product ≡ Income ≡ Expenditure on the product
Why two measures if the total must be the same? One reason is that two estimates
provide a check on one another with respect to accuracy. Another is that the two
measures break down into different components, some of which are more useful for
certain purposes than others.
GROSS NATIONAL PRODUCT (GNP)
This is the most important and widely used measure of national income. It is the most
comprehensive measure of a nation’s productive activities. It is defined as the value of all
final goods and services produced during a specific period, usually one year (Dwivedi,
1996). In other words it refers to that part of the GDP that is actually produced and
earned by or transferred to resident nationals of that country. Earnings of foreigners
which arise out of their domestic economic activities are thus excluded. For
Zimbabweans working abroad their income is included in the GNP of Zimbabwe. Where
there is substantial foreign participation in the economy and a large part of total domestic
income is earned and repatriated by foreigners and foreign companies as in many LDCs,
GDP will be much larger than GNP. As a result statistics of GDP growth may give a false
impression of the economic performance of a particular developing nation. GNP is
therefore a more appropriate measure of national income.
NET NATIONAL PRODUCT (NET NATIONAL PRODUCT)
Net National Product = Gross National Product– Depreciation. Net National Product
(NNP) is calculated by deducting from GNP the depreciation of existing capital stock
over the course of the period. The production of GNP causes wear and tear to the existing
capital stock, for example, machines wear out as they are used. It is a more accurate
measure of national product but in real life GNP is mostly because net investment (Gross
Investment – Depreciation) is difficult to measure especially as rate of depreciation is not
known (straight line, declining or reducing balance?) or may be quite inaccurate.
Depreciation estimates may also not be quickly available.
MEASUREMENT OF NATIONAL INCOME
There are three methods or approaches for measuring total output, namely :
1). Expenditure
2). Income method
3). Value Added or Output approach
A. The Expenditure Approach
Measuring total output by the expenditure method involves breaking down total spending
on all goods and services produced into four categories: (a) Expenditures by consumers
on goods and services (abbreviated simply to the letter C); (b)Expenditures by businesses
on capital goods (total investment spending, I); (c) Expenditure by government on goods
and services, G); and (d) Net exports (the total value of exports minus the total value of
imports, X-M). Because all spending done in the country falls into one or other of these
four categories, we can say that total expenditure is the sum of C+I+G+(X-M). We now
examine each of these four main components of total spending.
Consumption (C)
Consumption spending is the total of all outlays made by households on final goods and
services. In all countries it is by far the largest component of total spending. It covers
spending on an enormous range of items, including durable goods like television sets and
cars, non-durable goods like food and clothing, and personal services such as legal
advice, hairdressing, and dental care. But it usually excludes spending on houses, which
is customarily (and arbitrarily) treated as investment expenditure. C also excludes
purchases of second-hand goods that were produced in some earlier accounting period so
as not to double count the value of such output.
Government Expenditure on Goods and Services (G)
All governments payments to factors of production in return for factor services rendered
are counted as part of the GDP. Much of the spending done by governments in the
developed countries today takes the form of simple transfers of income from taxpayers to
those eligible for the wide range of income supplements available to assist the elderly, the
sick and the unemployed, or as payments of interest to holders of the public debt. Such
transfer payments do not represent spending on current production and consequently, are
not counted in national income determination. What is counted is government spending
on goods and services, many of which are bought by the government on behalf of the
public and which are ultimately "consumed" by households: education, health care
services, national defence, roads, water and sewage systems, postal services. Because so
many of these goods and services are provided "free" or in other ways that bypass
markets, it is difficult to determine their value in the same way that the value of the other
items entering into C would be determined. Consequently, national income accountants
value government spending on the basis of what the government pays for the goods and
services it requires.
Another complication with government spending on goods and services is that such
spending is often done on things like highways which are themselves capable of being
used to assist in the production of other goods. Logically, such spending should be
thought of as investment spending and included in the next category to be discussed.
Some countries produce their accounts in such a form that government spending can be
separated into two categories, current spending on goods and services, and investment
spending, but if the main concern is to understand the causes of year-to-year cyclical
fluctuations in the level of national income rather than the causes of its longer term
growth (which may be strongly affected by the level of investment as opposed to current
spending) it is convenient to stick with the traditional categories of spending which
emphasize the different motivations driving the spending decisions of ordinary
consumers, private investors and governments. Here, investment spending refers to
private investment spending unless otherwise stated.
Investment (I)
Investment is the production of goods that are not for immediate consumption. The goods
are called investment goods (inventories and capital goods including residential housing)
The total investment in an economy is called Gross Investment.
We count the construction of new houses as part of GDP, but we do not add trade in
existing houses. We do however, count the value of the estate agents commission in the
sale of existing houses as part of GDP. The estate agent provides a current service in
bringing buyer and seller together, and that is appropriately part of current output.
Total or gross investment Expenditure may be divided into two main categories:
(i)
Expenditure on capital goods—purchases of plant and equipment either to replace
existing capacity that is wearing out or to increase capacity. This is often called
fixed capital formation.
(ii)
Expenditure on inventories. Many businesses find it convenient or necessary to
hold certain supplies of goods on hand, in which case investment in inventories
may be considered voluntary. But business conditions are uncertain and so firms
may also find themselves holding stocks because they miscalculated demand. In
either case, firms are considered to be investing when they accumulate
inventories. On the other hand, if their inventories decrease they are
"disinvesting." Inventory investment is highly volatile, changing greatly in
amount and composition from year to year.
Gross investment, then, is the total amount of (usually private) spending during the
accounting period on capital goods (defined as structures, machinery and equipment, and
inventories). Because capital by its nature consists of things that are used in the
production of other goods and services, it is inevitable that it will wear out or
"depreciate." The amount necessary for replacement is called Depreciation or capital
consumption allowance. Gross Investment – Depreciation = Net Investment. Unless it is
continually renewed, the stock of capital in the economy will gradually be depleted.
Handling depreciation is one of the more difficult parts of national income accounting.
Again, the best treatment depends on what the data are meant to be used for. If the
concern is with the long-term growth of the economy, net investment (total investment
during the accounting period minus depreciation) is the important concept because it
measures the growth of the economy’s capital stock over time. But if the purpose is to
understand short term, annual fluctuations in the level of total spending it is better to
work with gross investment.
Net Exports (X-M)
A significant part of total spending in most countries goes toward the purchase of goods
produced abroad rather than domestically. As noted in discussing the circular flow, such
outlays represent spending which leaks from the domestic economy to the rest of the
world and is consequently treated as a negative entry in measures of total domestic
spending. But it is offset to a greater or lesser degree by the spending of non-residents on
goods produced and exported to international markets. It is often convenient, therefore, to
take domestic spending on imports and foreign spending on exports as a combined value,
usually called net exports, a value which may be positive or negative in any accounting
period depending on which component, exports or imports, is larger.
Summing these four expenditure components, C+I+G+(X-M), gives a single figure, the
total amount of spending done in the economy during the accounting period. It should be
possible to arrive at exactly the same figure by summing all income received in the
economy during the accounting period. (GDP = Y = C+I+G+(X-M),
B. Measuring Total Output by the Income Method
As seen in discussing the circular flow, what the firms producing the national output see
as costs of production, owners of productive factors see as income. Factor costs and
factor incomes are consequently the same thing viewed from different perspectives.
GDP = wages+ rents + interest + non-income charges
Quantitatively, by far the most important and certainly the simplest factor costs to
measure are the payments made by employers for labour services. These payments are
usually reported in the official statistics under a heading such as "Wages, salaries, and
supplementary labour income," with the latter term referring to employee benefits such as
pensions, workers’ compensation benefits, and employer contributions to unemployment
insurance funds or other worker social security schemes. Most other factor payments,
however, are much more difficult to track. Consider a farming operation. How should any
net income derived from farming be classified? Part of it must be a return to the services
of land the farmer is using ( rent). Part must be a return to the farmer’s own input of
labour (wages). Part might be considered a return to setting up and operating the
business(profit). These are difficult to separate. Because of such problems, the national
accounts typically use definitions of factor payments which owe more to convenience
than to the logic of factor classification: net income of farm operators, corporation
profits, net income of unincorporated business, and interest and other investment income.
Summing all these items yields the total amount received during the accounting period by
the owners of productive factors. But if this figure for factor costs or income is compared
with the total arrived at by the expenditure method, it falls considerably short of the
amount expected.
Indirect taxes and subsidies result in a discrepancy between the market price and the
factor cost of goods and services. The market price of most goods and services includes
indirect taxes, such as general sales tax, value- added tax and excise taxes with the result
that the market price is greater than the price the seller of the good or service receives. On
the other hand, subsidies paid to producers to keep the market price of certain goods and
services lower than it would otherwise be, result in the producers’ income being greater
than the market price. To calculate the GDP at factor cost, i.e. the amount received by the
factors of production that produced the goods and services concerned, we therefore have
to deduct indirect taxes from the GDP at market prices and add back subsidies. Thus:
factor cost ≡ market price – indirect taxes + subsidies. This point becomes important
when relate GDP to the incomes received by the factors of production.
C. Output Approach or the Value Added Method
A third method is available for estimating the total output of the economy and it is called
the "value added method" because it simply sums the net value of the output produced by
all the firms in the economy. GDP is the value of final goods and services produced. The
insistence on final goods is simply to make sure that we do not double count This
approach measures GDP in terms of values added by each of the sectors of the economy.
This is conceptually simple, but in practice complex because of the need to avoid double
counting. There are many interactions among firms in a modern economy. Many produce
goods that are sold not to final users as consumer goods, but to other firms. Consider a
firm producing power supply devices for computers. It buys components from suppliers,
assembles them, and sells the finished product to another firm which incorporates it into a
computer. If the value of the power supplies was measured when they were produced and
again as part of the price of the finished computer, total output would obviously be
exaggerated. Dealing with this requires that the value of each firm’s output be reduced by
the amount of all payments made by that firm to obtain inputs. This involves considerable
work, but the resulting data are often very useful because they yield a breakdown of
national output on an industry-by-industry basis. In formula terms:
Value Added = output of firm - output purchased from other firms.
If we follow the course of this process, we will see that the sum of values added at each
stage of process is equal to the final value of the item sold. Value added is also the basis
for the Value added Tax (VAT).
A problem associated with the value added approach is valuation of inventories of goods
produced but unsold. Unsold inventories are valued at market prices yet profits ( or
losses) have not been realised; prices may fall or rise; goods may not be sold. This means
that a rise in market prices causes a rise in value of the existing inventories. To avoid this
distortion a correction is made to eliminate changes in the value of inventories due to
price changes; that is stock appreciation should be deducted from the value.
The table below summarizes the relationships. For example from the third and fourth
columns NNP at market prices – indirect taxes add subsidies = national income at factor
cost.
Net factor
payments
Depreciation
GDP at
market
prices
GNP
at market
prices
Indirect taxes
less
subsidies
NNP at
market
prices
National
Income
at
Various*
items
factor
cost
Personal
Income
Personal
Tax
Personal
Disposable
income
* includes income that does not accrue to personal sector e.g. corporate taxation and corporate saving
Uses of National Income Accounting
1. Assists government in planning the economy. The accounts will show growth or
stagnation in the economy, alerting policymakers to the sort of action which ought to
be taken. Since national income accounts break the performance of the economy
down into its component parts, they provide policymakers with specific information
regarding the formulation and application of economic policy.
2. Permits us to measure the level of production in the economy over a given period of
time and to explain the immediate causes of that level of performance.
3. By comparing the national income accounts over a period of time, the long-run course
which the economy has been following can be plotted.
4. To compare standards of living of different countries- the problem is the countries
being compared use different currencies. The simplest means of dealing with the
problem is to use the Exchange rates between countries to convert the GNP of each
nation to a common currency e.g. US$. Most international comparisons use this
method. The second method used is Purchasing Power Parity. (a) Exchange rate
conversion- the method is simple and straightforward but this does not meet our
needs fully. We are seeking to measure differences in standard of living among areas,
but exchange rate reflects purchasing power of currencies for goods traded in
international markets. Goods and services not traded on international market may not
be correctly taken into account. (b) Purchasing power parity- the method involves
determination of the relative purchasing power of each currency by comparing the
amount of each currency required to purchase a common bundle of goods and
services in the domestic market of the currency’s country of origin. This information
is then used to convert the GNP of each nation to a common monetary unit. Estimates
using Purchasing Power Parity method are a more accurate indicator of international
differences in per capita GNP than exchange rate conversion method.
5. As a measure of welfare and national development, GNP per capita may be rising
over a period of time implying a rise in economic welfare and economic
development. Criticisms include the following- output of weaponry may rise, crime
may rise (use of more police), motor vehicle production (more pollution) may also
rise (showing increasing GNP) yet in terms the people are not better off or even
worse off. Output may also have been of capital goods. GNP per capita gives no
indication of how national income is actually distributed and who is benefiting from
growth of production. A rising level of absolute and per capita GNP may obscure the
reality that the poor are no better off than before. As an index of improved economic
welfare GNP growth rates are inadequate for the generality. Despite its shortcomings,
GNP provides a useful measure especially if it is accompanied by indicators like life
expectancy, infant mortality rates, education, literacy and income distribution.
6. For soliciting international aid from other countries or multilateral organizations.
7. National income and product estimates by sector of origin of national product reveal
contributions made by different sectors of the economy.
PROBLEMS OF GDP MEASUREMENT
GDP data are far from perfect measures of either economic output or welfare. Problems
of GDP measurement are:
(1) Badly measured outputs-some outputs do not go through the market, e.g. government
output (such as defence) is not sold in the market. Also there is nothing comparable
available that would make it possible to estimate the value of government output. It is
therefore valued at cost. Other non-market activities, including do -it- yourself work
and volunteer activities, are also excluded from GDP.
(2) Unrecorded economy- many transactions that go through the market escape
measurement. e.g. payment for a handyman’s services is not recorded in the GDP
data as it is unlikely to be declared, illegal traffic in drugs. The main problem is that
the relative importance of such activities may have been changing. If such activities
become more important over time , then measured real GDP will understate the rate
of growth of total economic activity. Why there might have been an increase in
unrecorded transactions (i) rising tax rates (which make it more tempting not to
declare sales or income,) and the growing importance of the so called informal
activities outside the modern sector of the economy.
(3) Data revisions- when they first appear, GDP data are not firm estimates. The reason is
that many of the data are not measured directly, but are based on surveys and guesses.
Considering the GDP is supposed to measure the value of all production of goods and
services in the economy, it is not surprising that not all the data are available within a
few weeks after the period of production. The data are revised as new figures come
in, as the CSO and RBZ improve their data collection methods and estimates.
Adjusting National Income Data to Allow for Price Changes
One difficulty with using money values to express national accounting magnitudes is that
the value of money may change over time. If there is a general rise in all prices, or a fall
in all prices, the monetary unit either decreases or increases in value. Trying to measure
distance with a ruler that shrank or expanded significantly between measurements would
obviously be a frustrating and not very useful activity. Inflation, defined as a general rise
in the price level, or deflation, a general fall in the price level, are common enough to
make it necessary to adjust national income data to remove the effect of changes in the
purchasing power of the dollar or other monetary unit being used to measure the value of
total output. This is done by developing indexes which show how the prices of the goods
and services produced in any one year have changed relative to the prices of those goods
and services in some other year. Setting up these indexes of prices is not difficult in
principle, although it can be an expensive, time-consuming task in practice. Consider a
simple example in which only a single commodity is the subject of interest, men’s shoes.
In the following table the price of men’s shoes in each year is compared with the price
prevailing in one particular year. The base year in the example is year 2000, (this can be
written as 2000=100) although it could have been any one of the five years. The price in
any particular year is then divided by the price in the base year to get the ratio of prices
shown in the third column. Because these ratios are usually expressed as percentages,
they are then multiplied by 100 to obtain the price index numbers shown in the last
column.
Year
1999
2000
2001
2002
2003
Price($)
20
40
50
60
80
Price Ratio
20/40=0.5
40/40=1
50/40=1.25
60/40=1.5
80/40=2
Price Index
50
100
125
150
200
These index numbers can now be used to adjust the data on the value of men’s shoes
produced in each year, thereby eliminating the effect of price changes from the series.
Suppose the following production information is available.
Year
1999
Output in Current 5
2000
2001
2002
2003
20
30
50
90
20
24
33.3
45
$
Output
in 10
Constant$
The current dollar values shown in the second column turn out to be quite misleading as
an indicator of the real changes in output. Because prices were lower in Year 1999 than
in the base year (Year 2000), the output in Year 1999 was understated, whereas, because
prices in Years 2000, 2001, and 2003 were higher than in the base year, the current dollar
production values overstated the volume of output. The conversion to (Year 2000)
constant dollars in the third column was done by dividing the current dollar values of
output for each year by the relevant index number (expressed as a percentage).
Men’s shoes are only one of thousands of commodities which are included in the total
national income and, in practice, it is not feasible to develop price indexes for each item
in this way. Instead, price indexes are built up for groups of commodities which are often
defined in terms of who buys them. For example, a commonly used index measures
changes in the amounts households spend on a selected bundle of goods and services.
One of the problems with this kind of index is that it is very costly to determine which
goods should be included in such a bundle. Surveys must be made of household buying
habits to determine which goods households are buying in significant quantities and the
relative importance of various goods in typical household budgets. Because of this, years
may elapse between redefinitions of the goods which are included in the index which
makes the information the index provides of dubious value toward the end of the
redefinition cycle.
When constructing large price indexes for adjusting national income data, most statistical
agencies build up a general index from a large number of specific commodity group
indexes, so that changes in expenditure patterns within the component groups will not
seriously affect the outcome. This composite index is known as a gross domestic product
deflator. It can be used to convert any current dollar value of gross domestic product to a
constant dollar basis using the relation:
Nominal GDP/Real GDP x 100 = GDP Deflator
GDP price deflator is an index calculated from nominal and real GDP. Thus, if the
deflator is known to have a value of 125 and nominal (current dollar) gross domestic
income is 50 billion dollars, real gross domestic income is $40 billion.
The measurement of per capita income
All countries have adopted the conventions (the United Nations Standard National
Accounts) for the calculations of Gross National Product (GNP) and Gross Domestic
Product (GDP), and GNP or GDP per capita is the commonest indicator of the level of
development. Economic growth refers to an increase in either of these indicators. There
are however well known problems associated with the calculation of national income in
poor countries and its use as an indicator of development:
1. The necessary data are often incomplete, unreliable or not available
2. The accounting conventions are not necessarily appropriate; the services of
women working in the household are excluded from national statistics yet in
many poor countries, especially in sub – Saharan Africa, women are often
responsible for running the family farm as well as working in the household.
3. In most poor countries, there is a large subsistence sector – that is, farmers may
well consume all or large proportion of what they produce, rather than sending it
to the market where it would be counted for the purposes of calculating national
income. Statisticians make an allowance for this non- marketed component of
output, and for rural capital formation that may not enter the national accounts –
house building, irrigation ditches – but it is generally accepted that the value of
the activities is underestimated, thus biasing downwards the national income
figures for poor countries.
4. Income may be overstated for developed economies because a number of items
that are included as income might better be seen as costs and hence excluded from
income- the cost of travelling to work, for example, or the cost of heating the
home in temperate climates.
5. Per capita (average) incomes tell us nothing about the distribution of income. Two
countries with similar per capita income distributions, with important implications
for the welfare of their populations and the nature and characteristics of the
development process.
Significant problems arise when international comparisons of income levels are made.
Income data measured in national currencies have to be converted into a common
currency, usually the US dollar, and an exchange rate must be chosen. If poor countries
artificially maintain overvalued exchange rates (that is, the price of foreign currencies in
terms of their domestic currency is too low), this will overstate the income of the country
expressed in US dollars. Offsetting this, however, is the fact that many goods and
services in poor countries are not traded and hence have no impact on the exchange rate.
Many of these necessities of life in poor countries – basic foodstuffs for example- are
very low priced in dollar terms, and a haircut in Zimbabwe will cost less than one in Paris
or London.
According to World Bank data:

Mozambique with an estimated GNP per capita of US 60 in 1992 was the poorest
country in the world;

Switzerland, with a GNP per capita of US$36080, was the richest
Is the average Swiss citizen 600 times better off than the average Mozambican? To put
that question slightly differently, does it make sense to state that in Mozambique, on
average, people live on 16 cents a day?
Clearly nobody in a developed economy could survive on such a low income. Given that
the majority of Mozambicans do survive, it must be the case that the necessities essential
for survival cost less in Mozambique than for example in Switzerland, and/ or $60 is not
a meaningful estimate of per capita income in Mozambique. This is not to deny that a
huge gap exists between the average incomes of very rich and very poor countries, nor
should it lessen our concern with such inequalities. But it does mean that the gap on
average is not as great as the statistics would suggest and a number of attempts have been
made to compute more meaningful comparisons.
Measurement of the Standard of Living
The value of this year's national income is a useful measure of how well-off a country is
in material terms. However, inflation increases the money value of national income but
does not provide us with any more goods to consume. Real national income is found by
applying the equation:
Real national income = Money national income/Retail price index x 100.
The standard of living refers to the amount of goods and services consumed by
households in one year and is found
(i) by applying the equation:
Standard of living = Real national income/ Population = national income per capita
A high standard of living means households consume a large number of goods and
services.
Or
(ii) by counting the percentage of people owning consumer durables such as cars,
televisions, etc. An increase in ownership indicates an improved standard of living. Or
(iii) by noting how long an average person has to work to earn enough money to buy
certain goods. If people have to work less time to buy goods, then there has been an
increase in the standard of living.
Interpretation of the Standard of Living
An increase in the standard of living may not mean a better life-style for the majority if:

Only a small minority of wealthy people consume the extra goods.

Increased output of certain goods results in more noise, congestion and pollution.

Leisure time is reduced to achieve the production increase.

There is an increase in the amount of stress and anxiety in society.
Common Misunderstanding
1. The various measures of the national product give us a tally of the nation’s income
for a year. However this does not measure the nation’s wealth .The nation has great
stock of capital goods .The stock of national capital is the sum total of everything
that has been preserved from all that has been produced throughout our economic
history. Interestingly, perhaps the greatest asset of modern economies is the skill and
education of the workforce. This is called ‘human capital’ but is not included in
measures of net capital stock owing to difficulty of measurement.
2.
If we are assessing someone’s wealth, one of the first things we would look at is
how much money they had and whether they owned stock and shares. However
these are excluded from the calculation of national wealth. Why? The answer is
because we have already counted them in the form of real wealth such as buildings
and machines. Money and other financial assets are only claims upon wealth and
hence are simply paper certificates of ownership. Similarly, varying the amount of
money in the economy does not directly make it any richer or poorer.