National Income & the Circular Flow of Income (HL IB Economics)

An Introduction to National Income

• National income accounting measures the economic activity within a country and provides insights into how a country is performing

• One of the main methods to determine economic activity is to measure the rate of change of output in an economy

• The output of an economy is called gross domestic product (GDP)

• Nominal GDP is the value of all goods/services produced in an economy in a one-year period 

• The circular flow of income model is used to illustrate national income and the flow of money, resources and goods in an economy

The Circular Flow of Income Model

• Money can enter or leave the circular flow of income in an economy
  

• Injections add money to the circular flow of income and increase its size

  • Increased government spending (G)

  • Increased investment (I)

  • Increased exports (X)
     

• Leakages (withdrawals) remove money from the circular flow of income and reduce its size

  • Increased savings by households (S)

  • Increased taxation by the government (T)

  • Increased import purchases (M)
     

• There are high levels of interdependence between households, firms, the government, the financial sector, and the foreign sector (foreign firms and households)
    

A diagram that shows the injections and leakages that influence the relative size of the circular flow of income
 

Diagram Analysis

• Government: Government spending (G) is an injection and taxation (T) is a leakage

• Financial sector: Investment (I) is an injection and savings (S) is a leakage

• Foreign sector: Exports (X) is an injection and imports (M) is a leakage
   

• The relative size of the injections and withdrawals impacts the size of the economy:

  • Injections > withdrawals = economic growth and increase in national income

  • Withdrawals > injections = economic decline and a fall in national income
     

• Changes to any of the factors that influence government spending, investment, consumption and net exports will increase/decrease the relative size of the circular flow of income

  • E.g. An increase in interest rates will increase savings (withdrawal), and reduce consumption and investment

Three Approaches to the Calculation of National Income

• With reference to the circular flow of income model, national income can be calculated using three possible approaches
   
  

  

Expenditure, income and output can be illustrated in the circular flow of income model
  

1. The expenditure approach

   • This approach adds up the value of all the expenditures in the economy in a year and includes consumption (C), government spending (G), investment (I) by firms and net exports (X - M)

   • Nominal GDP = C + I + G + (X-M)
      

2. The income approach

   • This approach adds up the payments (rewards) for the factors of production in a year and includes the wages from labour (W), rent from land (R), interest from capital (I) and profit from entrepreneurship (P)

   • National Income = W + R + I + P
      

3. The output approach

   • This approach adds up the value of all finished goods/services produced within the economy each year (national output)
       

• All approaches should provide the same figure

  • One agent's expenditure is another agent's income

  • The value of finished goods ready for sale is equal to the expenditure paid to acquire them
    

• The value of GDP is different to the volume of GDP

  • The value is the monetary worth

  • The volume is the physical number

Calculating Nominal GDP Using the Expenditure Approach

• Nominal GDP can be calculated using the value of the expenditure in an economy

  • GDP = Consumption (C) + Investment (I) + Government spending (G) + Exports (X) - Imports (M)

  • GDP = C + I + G + (X-M)

  • If any of the components of GDP increase, then economic growth is likely to occur
    

The components

• Consumption is the total spending on goods/services by consumers (households) in an economy 

• Investment is the total spending on capital goods by firms 

• Government spending is the total spending by the government in the economy

  • Includes public sector salaries, payments for the provision of merit and public goods etc.

  • It does not include transfer payments

• Net exports are the difference between the revenue gained from selling goods/services abroad and the expenditure on goods/services from abroad