C=f(Y)‘-(i)
5. Inflation
The depreciation of money via inflation can artincially boost the resultant national income figure. Unfortunately, no other method of measurement is available for national accounting purposes. The use of real GNP figures enables realistic comparisons to be made over a period of time. Despite these problems, national income accounting is a usefixl aid in the management of a country’s economy.
Influences on the national income
We now need to look a little more closely at the main elements in the national product or income, and try to understand how these are likely to change in response to the influences operating on them.
Consumption
Economics | Reference Book 1
economies. Any small percentage fluctuation in this type ofexper has important implications for the overall level of economic a<
/ V) hv £Q ~
^Community consumption (defense, education, etc) is expenc undertaken by the government and other agencies on behalf of the v community. There is a fundamental difference between the Government spending is the result of political and administmtive deck f hanges may take place therefore, for reasons that are not stn«i economic”, m the sense that they are not the result of considerations < cost and the availability of finance. Nevertheless, governments now fin— increasingly that they have to operate subject to various cost (economic^
• Personal consumption is assumed to be purely economic in nature and responsive to economic pressures. We assume, fairly reasonably, that consumption
rises
with disposable income, i.e. income left to the consumer after deduction of direct taxes, national insurance and pension contributions. We can also regard certain other regular payments as avmg a similar effect to tax, such as house mortgage interest payments. ?ny chan§e m *ect or mcome tax will change disposableincome and th^ Muence consumption. A reduction in income tax or mortgage ,terest rates would be expected to increase consumption and vice versa. ^Consumption is thus a function of income.
However, it is important to recognize that other factors also influence consumer intentions. People’s spending patterns may depend partly on *eir exf Rations of the future. If they expect to be earning more in the future, if there is confidence and a feeling that the economy is expanding, they are likely to be prepared to spend more now, perhaps with the e p of consumer credit. They are not afraid to commit future income to installment payments. On the other hand, if consumers are fearful ab~ut the future and expect an economic recession or overtime income to be cut, then they may reduce present consumption and seek to save more for the uncertain future.
Price expectations can also influence consumption —a rise encourages s^endmg now whereas an expected price fall will lead to the postponement of major spending decisions, such as car purchase or new furniture, etc.
Saving
paving is income not consumed. It is a residual which is influenced and determmed by consumption decisions - out of a given level of income, if people consume less then savings increase. Alternatively, if incomes increase then in most circumstances so also will savings. Savings like consumption, are a function of income as are imports and tax revenues guer mcomes
encourage the consumption of more foreign goods while or the government, as incomes and spending rises, more tax is collected.
Marginal propensity to consume (or save).- The marginal propensity to consume is that proportion of any change in disposable income that will
67 Concepts of National income
Expenditure Approach
be spent on consumption of goods and services. When we think in tsms of disposable (after-tax) income, we see that any disposable income not consumed must then be saved. Thus, the marginal propensity to consume (MPC) plus the marginal propensity to save (mps) is equal to one or unity, i.e. equal to the change in disposable income.
Injections into national income
We have so far concluded that consumption is a function of the level of income. However, three important injections ^ investment, government expenditure, exports- into the circular flow are subject to separate considerations and thus initially may not change in response to domestic income level changes.
Investment expenditure is influenced by a range of factors such as utilization of existing productive capacity, expected future levels of demand, new technology and the availability/cost of finance. Business firms do not alter investment decisions directly in response to income changes. Investment in short term economic models is not regarded as a function of income.
Government expenditure depends on political decisions and thus in the short run is not directly related to the level of income while exports are a function of income levels in other countries.
The Expenditure Approach defines National Income as comprising of the following major components: '
•Consumption (C) •Investment (I)
•Government expenditure (G) • Plus exports (X) minus imports (M)
It is assumed that investment and government expenditure offset saving and taxation. As we saw in the circular flow of income, total aggregate demand (expenditure) will equal total national income or output in an economy.
Mathematically, national income can be represented as follows:
Aggregate demand = C + I + G + (X-M) = National income
Consumption (C)is defined as the Personal Consumption spending by households to acquire finished goods and services and it forms the most substantial part of National Income. A household will consume both durables goods - appliances, automobiles, furniture, etc. and nondurable/consumable goods - clothing, food, personal care products, etc. Household consumption also includes paying for services like electricity, gas, telephone, repair and maintenance and many others. The second largest component in National Income is Government Expenditures (X).These are the expenses incurred by the federal, provincial
Economics | Reference Book 1
and^ocal governments on final goods and services. These expenditures can be infrastructure expenses such as construction of roads, dams, canals, parks’ etc. These are also expenses incurred for running the government m the form of salaries and operational expenses as well as the expenses incurred on defense/military development. It should be noted here that pensions, welfare payments and any unemployment compensations paid y the government do not count towards this expenditure.
Given the above, if there is free movement of the factors of production and some are underutilized in the economy, what will happen if government expenditure increases without a corresponding increase in texation? Assuming such expenditure is used to pay for goods and services, it becomes income for firms and their employees. This will increase the general level of income in an economy; national income will be at a new higher equilibrium level assuming other injections and leakages remain
There is likely to be a natural balance between the levels of saving and investment, as defined for purposes of national income calculation If saving is greater than investment, given that the other injections and withdrawals are in balance, then people are not consuming all the goods and services available for consumption. The immediate effect is for stocks (inventories) of goods to rise, bringing total investment (which includes stocks) back into balance with saving. However, firms will not continue to produce stocks that are difficult to sell, so they will cut back production. Th~is will involve both a reduction in real productive investment and a reduction in income. As the income level falls, actual saving will be reduced, thus restoring equality between saving and investment, but this relationship only holds when other injections and leakages balance and there is free movement of the factors of production.
The Income Approach is the reverse of the Expenditure Approach as it argues that all the Consumption and the Government expenditures generate revenues for firms producing goods and services as well as the suppliers, contractors and the workers involved in producing and delivering those goods and services. Hence, as all expenses result in income generation, then by adding up all the income generated, this should yield the same result as "attained through the expenditure approach. The components that are part of the income approach are shown in the following table.
Component of GDP: The Income Approach National Income Add: Compensation of employees Proprietor’s income Corporate profits Net interest Rental income Add: Depreciation Add: Indirect taxes minus subsidies Less: Net factor payments to the rest of the world
Less: Other __________ Gross Domestic product
In order to calculate the GDP under the income approach, wc bega®
mmk
calculating the National Income. The National Income is» akalatei as the sum of all the salaries earned, the profits made by 00TperaEk«& the net interest paid by businesses, the rental incomes earned and Ae iocoiaics of the entrepreneurs and partnership within the country. Eflfectiny-, tiis sum provides us with a total of all the incomes earned in all the segments of the economy.Once the National Income number is determined, the following adjustments are made to reach the GDP figure: 1. The depreciation expense is added since depreciation is a form of expense that does not generate any income for any household or firm etc. Depreciation is the expense incurred when useful life of the plant, machinery or any equipment is finished. Therefore it is regarded as an intangible expense that is not causing any change in cash but is recorded as an expense. So, by adding back depreciation to the National Income number, we effectively add back the potential income that was lost due to depreciation.
2. National Income also needs an adjustment of the incomes earned by foreigners working in the country as this income may only be partially spent within the country and the rest may be repatriated by the foreigners.
70 Concepts of National income
Hence, repatriation of funds by foreigners is deducted from National Income. Similarly, income earned by nationals working abroad also needs to be taken into account. In the case of Pakistan, a large number of Pakistani nationals work overseas and remit money to Pakistan (home remittance). This inflow of funds creates economic activity within the country and is considered towards calculating the National Income.
3. Deducting subsidies paid by the government to reduce the costs bome by the consumers of goods. Subsidies effectively reduce the cost of production and hence increase the net income of the seller of goods and services, while no services are received for such payments.
4. Finally, indirect taxes such as sales tax, withholding tax, fees, etc are added back to Net Income as these taxes are included in the prices of goods and services.
The Output Approach: The output approach to calculate GDP is to add
together the total value of all the goods and services produced in an economy. This measure of GDP sums up the values of output produced by each of the productive sectors in the economy using the concept of value added. Value added is defined as an increase in the value of a product at each successive stage of production. The GDP can be calculated using the formula given below:
GDP at market price = Value of output in an economy in a particular year - intermediate consumption Table 2.1-1 represents the total value of the services produced in Pakistan, Services Sector of Pakistan (figures in PKR million) ________________________________________________________
Since there are multiple stages involved in the production of goods and services, the output approach only considers the final value of goods or services while
2005-2006 2006-2007 2007-2008 2008-2009 2009-2010
Wholesale & Retail Trade 838,426 887,294 934,231 921,375 963,368 Transport, Storage &
Communication
496,073 519,486 539,297 558,703 574,101
Finance and
1
nsurance 265,056 304,514 338,386 312,818 277,555 Ownership of Dwellings 135,820 140,587 145,521 150,629 155,916 Public Administration &Defense
295,959 316,915 320,565 332,108 340,508 Community, Social &
Personal Services
480,217 518,344 569,044 619,412 667,793
calculating GDP. This is done to avoid the issue of double counting. Double counting occurs when the total value of a good or a service is included more than once in national output by counting the value of the gdod at each stage of its production.
Because of the complication of the multiple stages in the production of a good or service, only the final value of a good or service is included in total output. This avoids as described above. Let’s consider an example of meat production, where the value of the good from the farm may be 200 rupees/kg, then 400 rupees/kg from the butchers, and then 450 rupees/kg from the supermarket. The value that should be included in final national output should be PKR 450/ kg, not the sum of all those numbers, PKR 1050/kg. The values added at each stage of production over the previous stage are respectively PKR 200, 200 and 50 (total PKR 450). Their sum gives an alternative way of calculating the value of final output.
The Income Multiplier
Any increase in government spending will result in a more than proportionate change in national income. This is because there is a multiplying effect created when any given amount of new spending power enters into an economy. If the government spends money on a building contract, contractors and their employees will receive additional income. Most will be spent in the form of consumer expenditure and will then become someone else’s extra income, and so on.
Thus, if there is unemployment, an increase in government expenditure (or investment or exports) will lead to more people being employed. Increased expenditure will have not only primary effects on employment and expenditure but also secondary effects. However, the multiplying effect will not continue indefinitely, as leakages - savings, taxation, imports -will reduce each successive additional income round. The way in which an initial increase in expenditure is magnified as it is dispersed through the economic system can be measured by the multiplier. The employment multiplier, for example, is the ratio of the increment of total employment
Economics | Reference Book 2 which is associated with a given increment of primary employment in the economy. Thus, if increased government expenditure on
the nation’s infrastructure generated 250,000 jobs in the building and road construction industries which in turn increased total employment by 750,0, this would imply a value of three for the employment multiplier.
One of Britain’s most influential economists in the inter-war period, John MaynardKeynes, produced a formula in 1936 for the measurement of the income multiplier:
Income multiplier (k) = A I
Where
C
=marginal propensity to consume,△I =increase in investment ~ qwl—
It follows that larger the marginal propensity to consume (i.e. the greater the proportion of an increment of income which people are likely to spend), the greater the multiplier will be in an economy. Alternatively, a high propensity to save reduces the multiplier effect on income (and employment).
Provided that resources are unemployed in the economy, the rise in investment will generate employment. If the economy is near full employment, then an increase in investment will result in demand pull inflation which will stimulate a wage price spiral. However, Keynes in his book The General Theory of Employment, Interest and Money” (1936) was interested in the economic problems of a depressed economy in the 1930s, when prices were stable or declining ^ a state of deflation ^ together with high unemployment.
Is the multiplier dynamic?
Even Keynes admitted that the multiplier might not be as dynamic as was believed at first sight. A series of lags exists in an economy. A consumption lag might exist, as extra income generated might not result in an immediate increase in consumption it might be saved or used to pay off past debts. An investment lag might exist between planned investment and the actual expenditure in the economy. Finally, increased consumption might be satisfied initially from existing excess inventories accumulated during a recession, thus an output lag might exist.
Some of the extra income generated at each round in the multiplier process is lost to savings, which prevents the income generation process continuing forever. In addition, some of the income generated will be spent on imports and this will become income in foreign countries. A high propensity of import will therefore reduce the overall size of the multiplier. Another leakage is direct ana indirect taxation wmch also siphons off some of the increased income. Higher personal income means greater tax liability and thus nigher tax deductions. Also, most luxury and semiluxury goods are subject to value added tax or customs duty. Although this increases government tax revenue which could cover some of the initial expenditure from this source (public works), it does of
necessity reduce the size of the multiplier. This is sometimes referred to as fiscal drag.
This more conservative estimate of the multiplier’s size means that a huge increase in government expenditure might be needed in an economy to solve unemployment. In most cases this is not possible due to budgetary constraints, worries over the size of the national debt and possible inflation, together with an increase in imports which might have a negative impact on economic activity and employment.
The Distribution of Statistics show that during the recession year of 2008, the average (or per Income and Wealth capita) annual disposable income of Pakistanis was approximately USD
1027. However, almost nobody earns the average income, and it is more revealing to know the distribution of income, which shows the dispersion of individual
73 Economics | Reference Book 2 incomes. Every person in the nation does not earn the same amount of money as the others. Therefore, these can be sorted according to the income classes. Some of the people belong to the lowest income class which is below Rs. 5000 of income whereas few go into the income class of over Rs. 100,000.
The assumed income distribution of households is shown in the table below. Column 1 shows the different income-class intervals. Column 2 shows the percentage of families in each income class. Column 3 shows the percentage of the total national income that goes to the people in the given income class.
Columns 4 and 5 are computed from columns 2 and 3 respectively. Column 4 shows what percentage of the total number of families belongs to each income class or below. Column 5 shows what percentage of total income goes to the people who belong in the given income class or below.
The table above shows the wide spread of incomes. Although there’s always room at the top, not many people can earn enough to reach that income class. Most of the households belong to the middle classes of income.
Measuring Inequality A useful way to analyze inequalities in distribution of incomes is to check pmong different the percentage of income that goes to the lowest 50% of the population