National Income

How is national income calculated?

There are three methods for calculating the income of any economy:

• The income approach;
• The expenditure approach;
• The value-added approach.

The income approach

The income approach tries to sum up all the incomes earned in the economy. The provision of goods and services generates cash flows, termed income. There must be a corresponding payment for all the output generated in an economy. Calculation of imports is not necessary in this case as foreign purchases are automatically accounted for in this approach. The income approach totals incomes across several categories: employees' wages, proprietors' income, corporate profits, rent, interest, and taxes on production and imports.

The income approach formula is as follows:

\(\hbox{GDP} = \hbox{Total Wages + Total Profits +Total Interest + Total Rent + Proprietors income + Taxes}\)

The expenditure approach

The logic behind the expenditure approach is that someone else's income is someone else's expenditure. By summing up all the expenses in the economy, we can arrive at the exact figure, at least in theory, as in the income approach.

Intermediate goods, however, should be excluded from the calculation using this approach to avoid double counting. The expenditure approach, therefore, considers all the spending on final goods and services produced in an economy. Expenditures across four major categories are considered. These categories are consumer spending, business investment, government spending, and net exports, which are exports minus imports.

The expenditure approach formula is as follows:

\(\hbox{GDP} = \hbox{C + I + G + NX}\)

\(\hbox{Where:}\)

\(\hbox{C = Consumer Spending}\)

\(\hbox{I = Business Investment}\)

\(\hbox{G = Government Spending}\)

\(\hbox{NX = Net Exports (Exports - Imports)}\)

The value-added approach

Recall that the expenditure approach ignored the intermediate values of the goods and services and only considered the final value? Well, the value-added approach does the opposite. It adds all the additional values created at each step of the production process. However, if each value-added step is calculated correctly, the total sum should equal the product's final value. This means that, at least in theory, the value-added approach should arrive at the same figure as the expenditure approach.

The value-added approach formula is as follows:

\(\hbox{Value-Added} = \hbox{Sale Price} - \hbox{Cost of Intermediate Goods and Services}\)

\(\hbox{GDP} = \hbox{Sum of Value-Added for All Products and Services in the Economy}\)

The three ways of calculating national income provide a theoretical backbone for accounting for a country's economic performance. The reasoning behind the three methods suggests that, in theory, the estimated federal income should be equivalent, whatever approach is used. In practice, though, the three approaches arrive at different figures due to the difficulties in measurement and a massive amount of data.

Measuring national income in several different ways helps to reconcile the accounting differences and understand why they arise. Understanding these measurement methods helps to find the driving factors behind national income creation and, therefore, economic growth of a country.

Measurement of National Income

The measurement of national income is a complex task, without a doubt. There are few ways to measure a nation’s income, but they are more or less similar to each other. We call these measurement tools national income metrics.

No matter what the metric used to measure the national income is, the idea behind what to measure is more or less the same. What is a better way than following the very thing that we use for the exchange in an economy to understand the income in an economy? In any economy, every transfer, every flow of money leaves a trail behind. We can explain the general flow of money with the circular flow diagram.

Fig. 1 - The circular flow diagram

As demonstrated in Figure 1, there is a continuous flow of money as spending, expenses, profits, income, and revenue. This flow happens due to goods, services, and factors of production. Understanding this flow helps us to gauge the size and structure of the economy. These are the things that contribute to a nation’s income.

National income is measured from these circular movements. For example, GDP equals the total amount spent by households on the final goods.

• The most commonly used approaches to measuring national income are as follows:
  • Gross Domestic Product (GDP)
  • Gross National Product (GNP)
  • Net National Product (GNI)

Gross Domestic Product

In the contemporary world, we most often use Gross Domestic Product (GDP) as a measurement of a nation’s income. No matter what your background is, it is highly likely that you have come across this term at least once in your life. In a closed economy, GDP measures the total income of every agent and the total expenditure made by every agent.

In light of this knowledge, we say that the gross domestic product (Y) is the sum of the total investments (I), total consumption (C), government purchases (G), and net exports (NX), which is the difference between exports (X) and imports (M). Therefore, we can denote a nation's income with an equation as follows.

\(Y = C + I + G + NX\)

\(NX = X - M\)

Gross National Product

Gross national product (GNP) is another metric that economists use to evaluate a nation’s income. It is different from GDP with some minor points. Unlike GDP, the gross national product doesn’t limit a nation’s income to its borders. Therefore, citizens of a country can contribute to the country’s gross national product while producing abroad.

GNP can be found with a few additions and subtractions to GDP. For calculating the GNP, we aggregate GDP with any other output produced by the citizens of the country outside of the country’s borders, and we subtract all output made by the foreign citizens within a country’s borders. Thus, we can arrive to the GNP equation from the GDP equation in the following way:

\(GDP = C + I + G + NX\)

\(\alpha = \text{Overseas citizen output}\)

\(\beta = \text{Domestic foreign citizen output}\)

\(GNP = C + I + G + NX + \alpha - \beta\)

Net National Product

All of the national income metrics are rather similar, and obviously, net national product (NNP) is not an exception. NNP is more similar to GNP than to GDP. NNP also takes any output outside a country’s borders into account. In addition to that, it subtracts the cost of depreciation from GNP.

We can denote the net national product of a country with the following equation:

\(NNP=GNP - \text{Depreciation Costs}\)

Components of national income

The five main components of national income from the accounting standpoint are:

• compensation of employees,
• proprietors' income,
• rental income,
• corporate profits, and
• net interest.

Table 1 below shows these five main components of national income in practice.

Table 1. National income components. Source: Federal Reserve economic data¹

The components of national income can also be understood through the components of the gross domestic product. Although we can calculate the national income from different standpoints on the circular flow diagram, the GDP approach is the most commonly used one. We list the components of GDP as follows:

• Consumption
• Investment
• Government Purchases
• Net Exports

We can think of consumption as any spending made by households except the spending made on real estate. In the circular flow diagram, consumption is the flow from final goods markets to households. For example, going into an electronics shop and buying a brand new laptop surely will be added to the GDP as consumption.

The second component of national income is investment. Investment is buying any good that is not a final good or a good that can contribute to the production of the final goods and services. The computer you bought in the previous example could be classified as an investment if a company bought it for you as an employee.

The third component of national income is government purchases. Government purchases are any spending made by a government for the exchange of any goods and services. If your government is paying the wage of soldiers and doctors, you can think of their wages as government purchases.

Finally, the last component is the net exports. Whether a domestically produced good or service is consumed outside of the country’s border (export) or whether a good or service produced abroad is consumed locally (import), we include them in the net exports component. The net exports are the difference between total exports and total imports.

National income vs. GDP

Is there a difference between national income vs. GDP? Calculating national income using the expenditure approach is the same as calculating nominal GDP (Gross Domestic Product)!

Recall the formula for the expenditure approach:

\(\hbox{GDP} = \hbox{C + I + G + NX}\)

\(\hbox{Where:}\)

\(\hbox{C = Consumer Spending}\)

\(\hbox{I = Business Investment}\)

\(\hbox{G = Government Spending}\)

\(\hbox{NX = Net Exports (Exports - Imports)}\)

This is the same as GDP! However, this figure is nominal GDP or GDP at current prices. Real GDP is the GDP figure that would allow us to see if economic growth occurred.

If the prices are rising but without corresponding increases in value, it may seem like the economy has grown in numbers. However, to find the actual value, real GDP needs to be used to compare the prices of a base year to the current year. This critical distinction lets economists measure real growth in value rather than inflationary price increases. A GDP deflator is a variable that accommodates the nominal GDP for inflation.

\(\hbox{Real GDP} = \frac{\hbox{Nominal GDP}} {\hbox{GDP Deflator}}\)

National Income Example

Let's back our national income knowledge up with some concrete examples! In this section, we will give an example of the national income of three different countries as represented by GDP. We have selected these three countries since they have clear differences in their national incomes:

• United States of America
• Poland
• Ghana

Let us start with the United States of America. The United States has the highest nominal gross domestic product and surely an extremely complex mixed-market mechanism. Our second country is Poland. Poland is a member of the European Union and its sixth-largest economy by GDP. To clarify the difference, we have selected Ghana. Ghana has one of the highest GDP per capita in West Africa. Ghana’s main income is from raw export materials and rich resources.

First, let us illustrate the differences between Poland’s and Ghana’s GDPs. In Figure 2 the vertical axis represents the GDP in billions of dollars. The horizontal axis represents the time interval taken into account.

Fig. 2 - GDP of Ghana and Poland. Source: The World Bank²

But the most shocking results can only be seen when we compare them to the national income of the United States. We have illustrated the results in Figure 3 below where we can clearly see the gap between the national income of the United States and other countries.

Fig. 3 - GDP of selected countries. Source: The World Bank²

Gross national income example

Let's take a look at the gross national income example by looking at the US!

Figure 4 below shows the US real national income growth between 1980-2021.

Fig. 4 - US national income growth between 1980-2021. Source: Bureau of Economic Analysis³

It can be seen from Figure 4 above that the US real national income growth has been fluctuating over the period. Major recessions such as the 1980s oil crisis, the 2008 Financial crisis, and the 2020 COVID-19 pandemic mark periods of negative economic growth. However, the US economy has been growing between 0% and 5% for the remainder of the periods. The post-pandemic recovery from negative growth to just over 5% gives an optimistic forecast for the US economy.