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Measuring National Income

Free essay example:

Sean Okundaye

Economics

Mr S. Hill

Measuring National Income

Circular Flow of Income Model

In the circular flow of income model there are two sectors: households and firms. Households are the ones who buy the country’s output of both goods and services and own all of the economy’s factors of production. They are the suppliers of these factors of productions and receive payment for supplying these factors to firms. Firms hire factors of production from households and use these factors to produce the country’s output of goods and services.

A table of the factors of production and the income received can be seen below.

Factor of production

(provided by households)

Payment to the factor

 (provided by firms)

Labour

Wage

Land

Rent

Capital

Interest

Entrepreneurship

Profits

This is the basis for the circular flow of income two-sector model. Households provide factors of production and in turn, receive income. They then buy these goods and services which have been produced by the firms. These products have been produced using the income received and in this way the income is circulating throughout the economy.

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.
  1. 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.
  1. 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.

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Response to the question

The essay responds to the question strongly, offering a number of ways which are practical to measure national income. I would've liked a discussion of what national income is, or what GDP is, to allow the marker to see the ...

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Response to the question

The essay responds to the question strongly, offering a number of ways which are practical to measure national income. I would've liked a discussion of what national income is, or what GDP is, to allow the marker to see the understanding is there!

Level of analysis

The analysis is strong in this essay, with the circular flow of income being explained particularly well. The diagram is a bit misaligned, but that is to be expected with the formatting. The explanation of savings being a leakage is good, as this is a common mistake. If I were doing this essay, I would've gone further to say that the amount of savings depends on the marginal propensity to save, which is affected by job security and the general feeling for the economy. It would've been nice to have seen aggregate demand mentioned in "the expenditure method", and a diagram showing a shift in aggregate demand due to a change in one of the components would've increased the analysis marks. If the essay wanted to take things further, looking into the multiplier effect would've been wise. When talking about "the income method", I would always note that transfer payments should not be included. A short definition of what transfer payments are would suffice.

Quality of writing

This essay is structured well, however I would've liked a conclusion which rounded it all together. Although this question didn't prompt evaluation, a strong conclusion posing a justified judgement to which method is most suitable would've been wise. Spelling, punctuation and grammar are strong throughout and technical terms are used fluently.


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Reviewed by groat 21/02/2012

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