Measuring National Income

   

Leakages and Injections

However, households do not spend all of the income that they receive, as illustrated by the above diagram, which is simply a simplified model of an economy. Households are also able to save part of their income. Saving is the foregoing of current consumption to allow for consumption in the future. People save by putting money in banks, building societies and other financial institutes.

Savings is a leakage from the circular flow of income. This is because it is income received but not used for expenditure for goods and services. Since households do not buy all the output that is produced, then firms will have a surplus of unsold goods and as a result they will reduce their output. This will lead to the firms using a lower number of factors of productions and therefore pay less income. This shows that saving causes the amount of income circulating in an economy to fall.

Firms do, however, have access to the savings of households by borrowing money from financial institutions such as banks or pension funds. This money can be used to increase their stock of capital and broaden their output. This is otherwise known as investment and is an injection into the circular flow of income. Investment allows the income circulating the economy to rise.

If households buy goods and services from abroad, then some of their income exits the economy’s circular flow. Therefore imports are leakages because they represent expenditure of income which is not returned to the firms. Foreigners buy the country’s exports of goods and services. Exports are an injection into the circular flow.

Firms and households are not the only sectors acting in an economy. Some of the income earned by households must be paid to the government in the form of taxes, Therefore taxes are a leakage from the circular flow. Governments spend money in the economy on things such as schools, campaigns, infrastructure, healthcare and many more. This sort of government expenditure represents an injection into the circular flow. Below is a four-sector circular flow model with leakages and injections.

REMEMBER: Savings is a leakage from the circular flow of income. This is because it is income received but not used for expenditure for goods and services. Since households do not buy all the output that is produced, then firms will have a surplus of unsold goods and as a result they will reduce their output. This will lead to the firms using a lower number of factors of productions and therefore pay less income. This shows that saving causes the amount of income circulating in an economy to fall.

           

Methods of Measuring National Income

GDP (Gross Domestic Product) is the most common measurement of a country’s national income. There are three ways to calculate this figure.

1. The output method: This measures the actual value of the goods and services produced. This is calculated by summing all of the value added by all the firms in an economy. By “value added”, it means that at each stage of a production process, we deduct the cost of inputs, so as not to double count the inputs.

2. The income method: This measures the value of all the incomes earned in the economy. This method measures the value of the wages, rent, interest and profits.

3. The expenditure method: This measures the value of all spending on goods and services in the economy. This is calculated by summing up the spending by all the different sectors in the economy. These include:

• Consumption (C) which is spending by households
• Investment (I) which is spending by firms
• Government spending (G)
• Net exports (X-M) which is spending by foreigners on exports minus spending on imports

The expenditure method measures the value of expenditure on goods and services.