National Income measurement approaches

1. Approaches used in Measuring NY
There are three main approaches used to measure national
income. These are;
• Income approach
• Expenditure approach
• Product/Output approach

2. Income Approach
• Using this approach, we add up incomes received by individuals, firms
and government from the exchange of goods and services inform of
wages/salaries, rent, profit and interests. All these incomes should be
from productive activities. We exclude incomes from illegal activities
and also black market.
• The methods also excludes transfer payments like gifts, pocket
money, grants e.t.c
Hence, NY= W/S+R+I+P

3. Expenditure approach
• Using this approach, we add expenditures on final commodities. We
consider final goods so as to avoid double counting.
• For example, expenditure on bread and expenditure on wheat which
is used to make bread would result into double counting. We thus
consider on bread which is a final good.
• We thus add expenditures from all sectors of the economy.
NY=C+I+G+ (X-M).

4. Product/Output approach
• This is the most direct way that involves estimating the value of output produced
in the country. We add value added on output in a given year.
• By value added we mean the difference between the value of final goods and
that of intermediate inputs at every stage of production.
For example;
Stage 1: A farmer grows cotton and sells it to a ginnery at 1,000=. This represents
an income of 1,000 to the farmer. The value added is 1,000
Stage 2: The ginnery sorts it and sells it to a spinner at 1500=. Value added is 500
Stage 3: the Spinner uses the sorted product to make thread and sells it at 2500.
value added is 1000
Stage 4: Another firm uses thread to make a shirt and sells it at 4000. value added
is 1500

5. • Total value added is 1000+500+1000+1500
= 4000
The value added is equal to the value of the final product.

6. Determinants of National income
• Technological progress
• Level of human capital development
• Political climate
• Size of the market
• Country’s stock of resources
• Government policy

7. National income and Standards of living
Per capita income
This measures average income per individual
This is obtained by;
Total income/total Population
However, it is not the best measure for standards of living.
It does not consider the level of income distribution, level of inflation,
nature of products produced, political climate, quality of goods
produced, level of infrastructural development, e.t.c

8. Equilibrium Output determination
The Two-Sector Model of National Income Determination
• According to Keynesian theory of income determination, the
equilibrium level of national income is a situation in which aggregate
demand (C+ I) is equal to aggregate supply (C + S) i.e.
• In a two-sector economy, the aggregate demand (C+ I) refers to the total spending
in the economy i.e., it is the sum of demand for the consumer goods (C) and
investment goods (I) by households and firms respectively.

9. • The equality between saving and investment can be seen directly from
the identities in national income accounting. Since income is either
spent or saved, Y = C + S.
• Without government and foreign trade, aggregate demand equals
consumption plus investment, Y = C + I. Putting the two together, we
have C + S = C + I, or S = I.
Numerical Example:
• Given the empirical consumption function C= 100+0.75 Y and I = 1000, calculate
equilibrium level of national income. What would be the consumption expenditure
at equilibrium level national income?

11. Determination of National Income in Three-Sector
Economy
• The three-sector economy involves three sectors namely, households,
business, and government.
• The addition of the government in an economy results in bringing two
variables in an economy. These variables are government expenditure
(act as injections to income) and taxation (act as leakage or
withdrawals from income).
• In other words, the government expenditure increases the aggregate
demand, while taxation reduces the aggregate demand.

12. • Let us understand the effect of government expenditure and taxation
on the level of national income assuming that the government is
following a balanced budget policy. In such a case, the government
expenditure (G) and government taxation (T) is equal.
• At the equilibrium point, AD = AS
In a three sector model economy, equilibrium output is determined as;
Y = C + I + G
Where, C = a + bYd
Yd = Y – T

13. T = Lump-sum tax
• Substituting the values of C and Yd, we get the level of national income
at equilibrium point:
Y = a + bYd + I + G
Y = a + b(Y – T) + I + G
Y = a + bY – bT + I + G
Y (1-b) = a-bT + I + G
Y = 1/1-b (a -bT + I + G)

14. Numerical example
• Let us determine the level of national income by assuming
consumption function as C = 100 + 0.75Y and I = 100. The government
is following a balanced budget policy, according to which G = T= 50.
• In such case, the national income at equilibrium point would be as
follows:
Y = 1/1-b (a-bT + I + G)
Y = 1/10.75 (100 -0.75*50+ 100 + 50)
Y = 850

15. National Income and Consumption and Saving
Functions
• Although national income accounting provides estimates of the
nation’s output, it does not explain why the nation’s output is at a
certain level or why it increases more rapidly in some years than in
others.
• In a simple Keynesian model aggregate demand - the sum of society’s
expenditures on consumption and investment - determines the
equilibrium level of income. If aggregate demand changes, the
equilibrium level of income also changes.

16. The Consumption Function:
• Many different factors, including tastes and preferences, income and
interest rates, determine consumption. For example, if the income of
one household is greater than the income of another, the former is
likely to consume more.
• Even if their incomes are the same, however, they will spend different
amounts on consumption if their attitudes toward thrift differ.
Similarly, households vary their consumption in response to changes in
interest rates.

17. • Although many factors affect consumption, aggregate income is the
most important by far. Consequently, we shall concentrate on the
relationship between consumption and income, called the
consumption function.
• In Keynesian consumption function, consumption is assumed to vary
directly with income. Specifically, consumption is assumed to increase
with income, with the increase in consumption being less than the
increase in income.

18. • The consumption function is expressed as:
C = a + bY (a > 0, 0 < b < 1).
where C and Y represent real consumption and real income,
respectively. The equation indicates that consumption is a linear
function of income. In the equation, ‘a’ and ‘b’ are constants, called
parameters. Consumption, C, and income, Y, are variables.
• The parameter b, called the marginal propensity to consume or MFC,
is the slope of the consumption function. If ΔY denotes a change in
income and ΔC denotes the change in consumption associated with
the change in income, b, the MPC, equals ΔC/ΔY.

19. • For example, if income increases by KES 200 and, as a result,
consumption increases by 150 Units, the MPC will be 150 divided by
200 which is equal to 0.75. In postulating his consumption function,
J.M. Keynes assumed that consumption increases as income increases,
but by a smaller amount. Thus implies that b, the MPC, must lie
between 0 and 1.
• The parameter a is the portion of consumption which does not vary
with income, i.e., a represents the consumption which would occur if
income were 0. Short-run studies of the consumption function show
that a is positive.

20. • The parameter a is the portion of consumption which does not vary
with income, i.e., a represents the consumption which would occur if
income were 0. Short-run studies of the consumption function show
that a is positive.

21. The consumption function shows the level of consumption (C) corresponding to
each level of disposable income (Y) and is expressed through a linear consumption
function, as shown by the line marked C = f(Y) in figure above.
When income is low, consumption expenditures of households will exceed their
disposable income and households dissave i.e., they either borrow money or draw
from their past savings to purchase consumption goods.
The intercept for the consumption function, a, can be thought of as a measure of
the effect on consumption of variables other than income, variables not explicitly
included in this simple model.
The Keynesian assumption is that consumption increases with an increase in
disposable income, but that the increase in consumption will be less than the
increase in disposable income (b < 1). i.e., 0 < b < 1.

22. Marginal Propensity to Consume (MPC)
• The consumption function is based on the assumption that there is a constant
relationship between consumption and income, as denoted by constant b which is
marginal propensity to consume.
• The concept of MPC describes the relationship between change in consumption
(∆C) and the change in income (∆Y). The value of the increment to consumer
expenditure per unit of increment to income is termed the Marginal Propensity to
Consume (MPC).

23. Average Propensity to Consume (APC)
• Just as marginal propensity to consume, the average propensity to
consume is a ratio of consumption defining income consumption
relationship. The ratio of total consumption to total income is known
as the average propensity to consume (APC).

24. The table below shows the relationship between income consumption
and saving.

25. APC is calculated at various income levels. It is obvious that the proportion of income spent
on consumption decreases as income increases.
What happens to the rest of the income that is not spent on consumption? If it is not spent,
it must be saved because income is either spent or saved; there are no other used to which
it can be put. Thus, just as consumption, saving is a function of income. S=f(Y).
The Saving Function
• The saving function shows the level of saving (S) at each level of disposable income (Y).
The intercept for the saving function, (-a) is the (negative) level of saving at zero level of
disposable income at consumption equal to ‘a’.
• By definition, national income Y = C + S which shows that disposable income is, by
definition, consumption plus saving. Therefore, S = Y – C. Thus, when we represent the
theory of the consumption-income relationship, it also implicitly establishes the saving-
income relationship.

26. The Marginal Propensity to Save (MPS)
• The slope of the saving function is the marginal propensity to save. If a
one-unit increase in disposable income leads to an increase of mango
consumption, the remainder (1 - b) is the increase in saving.
• This increment to saving per unit increase in disposable income (1 - b)
is called the marginal propensity to save (MPS). In other words, the
marginal propensity to save is the increase in saving per unit increase
in disposable income.

27. Marginal Propensity to Consume (MPC) is always less than unit, but greater than
zero, i.e., 0 < b < 1 Also, MPC + MPS = 1; we have MPS 0 < b < 1.
Thus, saving is an increasing function of the level of income because the marginal
propensity to save (MPS) = 1- b is positive, i.e., saving increase as income increases.
Average Propensity to Save (APS)
• The ratio of total saving to total income is called average propensity to save (APS).
Alternatively, it is that part of total income which is saved.