National Income & The Circular Flow of Income (DP IB Economics)
Revision Note
Written by: Steve Vorster
Reviewed by: Jenna Quinn
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
Examiner Tips and Tricks
Remember to consider the net effect and proportionality of the injections and withdrawals. For example if the size of the government spending is large, it is likely to completely outweigh the combined withdrawals of savings and imports.
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
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)
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
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
Worked Example
The table provides national income data for Vietnam in 2019 - presented in US$. Calculate the nominal GDP using the expenditure method [2]
Category | Value in US$ millions |
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Answer:
Step 1: Determine which of the data presented is relevant to the calculation
GDP = C + I + G + (X-M)
So income tax is not relevant (it is a leakage)
Step 2: Substitute the relevant values into the formula
GDP = C + I + G + (X-M)
GDP = 11255 + 8927 + 15697 + (8532 - 4957)
Nominal GDP = 39,454 $m
(Two marks for the correct answer or 1 mark for any correct work in the process)
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