National income is the total value a country’s final output of all new goods and services produced in one year. Understanding how national income is created is the starting point for macroeconomics.
The national income identity
This relationship is expressed in the national income identity, where the amount received as national income is identical to the amount spent as national expenditure, which is also identical to what is produced as national output. Throughout macroeconomics the terms income, output and expenditure are interchangeable.
See also: the circular flow of income
National income accounts
Since the 1940s, the UK government has gathered detailed records of national income, though the collection of basic data goes back to the 17th Century. The published national income accounts for the UK, called the ‘Blue Book’, measure all the economic activities that ‘add value’ to the economy.
National output, income and expenditure, are generated when there is an exchange involving a monetary transaction. However, for an individual economic transaction to be included in aggregate national income it must involve the purchase of newly produced goods or services. In other words, it must create a genuine addition to the ‘value’ of the scarce resources. In the case of a transaction involving selling a second-hand good, and which was new two years ago, no value is added to national income – though the original purchase of the new good does. Transactions which do not add value are called transfers, and include second-hand sales, gifts and welfare transfers paid by the government, such as disability allowance and state pensions.
The creation of national income
The simplest way to think about national income is to consider what happens when one product is manufactured and sold. Typically, goods are produced in a number of ‘stages’, where raw materials are converted by firms at one stage, then sold to firms at the next stage. Value is added at each, intermediate, stage, and, at the final stage, the product is given a retail selling price. The retail price reflects the value added in terms of all the resources used in all the previous stages of production.
In accounting terms, only the value of final output is recorded. To avoid the problem of double counting, only the value of the final stage, the retail price, is included, and not the value added in all the intermediate stages – the costs of production, plus profits. In short, national income is the value of all the final output of goods and services produced in one year.
For example, consider the production of a motor car which has a retail price of £25,000. This price includes £21,000 for all the costs of production (£6,000 for components, £10,000 for assembly and £5,000 for marketing) plus £4,000 for profit. To avoid double-counting, the national income accounts only record the value of the final stage, which in this case is the selling price of £25,000.
When goods are bought second-hand, the transaction does not add new value and will not be included in national output. If second-hand goods are included, double-counting will occur, and this would falsely inflate the value of national income.
For example, if the car in question is sold in two year’s time for £15,000 it would provide the owner with money, but the sale will not add to national income. If it were included in national income, it would make the value of the car £35,000 – the initial £25,000 plus the second hand value of £15,000. This is clearly not the case, so any future second-hand sales are not included when valuing national income. Such second-hand transactions are called transfers.
Calculating national income
Any transaction which adds value involves three elements – expenditure by purchasers, income received by sellers, and the value of the goods traded. For example, if a student purchases a textbook for £30, spending = £30, income to the bookseller = £30, and the value of the book = £30. All of the transactions in an economy can be looked at in this way, giving us three ways to measure national income.
There are three methods of calculating national income:
- The income method, which adds up all incomes received by the factors of production generated in the economy during a year. This includes wages from employment and self-employment, profits to firms, interest to lenders of capital and rents to owners of land.
- The output method, which is the combined value of the new and final output produced in all sectors of the economy, including manufacturing, financial services, transport, leisure and agriculture.
- The expenditure method, which adds up all spending in the economy by households and firms on new and final goods and services by households and firms.
Chained value measurement
The components of national output are valued according to their importance to the overall economy. The weights used were based on estimates made every 5 years, but, from 2003, an annual adjustment to the weightings was introduced to improve the reliability of the weighting – a process called annual chain linking. This allowed for a more up-to-date, and therefore a more accurate measure of changes to the level of national income.
The main components of UK National Income
The percentage contribution of different components in the three different measures are shown below:
National Income, by ‘type’ of income:
With around 30m workers in the UK, and over 2m firms*, wages and profits contribute the majority of income in the UK.
(*2.15m according to the ONS)
National output, by sector of the economy:
In terms of output, services dominate the UK economy, contributing around 80% of national output, with production a distant second. However, this is a typical profile for a developed economy – the more developed the economy the more that income is allocated towards purchasing services rather than manufactured goods.
In terms of spending, UK households account for the majority of spending, export spending the next most important. Spending on capital goods by firms, and spending on public goods, merit goods, and transfers by government accounts for the rest.
Source – ONS
Gross Domestic Product – GDP
Gross Domestic Product (GDP) is the most important aggregate of national income for accounting purposes, and for economic analysis. In the UK, GDP is derived from the gross value added (GVA) of all the UK’s individual producers, industries or sectors over one year, using the ‘output’ method.
As the level of economic activity between households and firms increases, output is also likely to increase. However, under certain circumstances the price level may also be driven up.
The nominal value of national income, or any other aggregate, is the value of national output at the prices existing in the year that national income is measured – that is, at current prices. In simple terms the ‘nominal’ value of national income can be found by multiplying the quantity of output by the retail (market) price of this output.
If demand increases at an unsustainable rate, resources become increasingly scarce, and firms will raise prices. Similarly, wages are likely to rise as the labour market clears and unemployment falls. The more that workers are needed the higher the wage rate. This will act as an incentive for workers to enter this industry. The combined effect of higher wages and prices is that the nominal value of national output may be driven up, rather than its real value.
To find the real value of changes in output under inflationary conditions, the effects of any general price increase (price inflation) must be taken into account. This is done by holding prices constant from a starting measure, called the base year.
For example, if, in a hypothetical economy, 100 pens are produced and sold for £1 each in year 1, the nominal value of these transactions is £100. If, in year 2, inflation pushes prices up to £1.20p per pen, but, as in year 1, only 100 pens are sold, the nominal value at current (year 2) prices will rise to £120. However, the nominal value has only risen because of inflation, so to adjust the nominal value to find the real value we take the constant price of £1 – which is the price of pens at the start of our measurement in the base year, year 1. However, if in year 3 110 pens are sold at £1.20, the nominal value at current prices will be £132 (an increase of 32%), but the real value at constant (year 1) prices will be only £110 (a real increase of only 10%). Therefore, to arrive at real values the economist must take out the effects of price inflation by holding prices constant in terms of the prices existing in the base year.
Recent changes to UK national income
After a sustained period of rising national income from the previous recession, which ended in 1992, the UK, like most other advanced economies, entered a recession in the third quarter of 2008.
The recession lasted until the fourth quarter of 2009. Growth returned in 2010, but, following negative growth in the fourth quarter of 2010, the UK economy failed to recover fully, with growth in the third quarter of 2011 a modest 0.5%, with a further drop to 0.2% in the last quarter of 2011. By early 2013 the UK had returned to modest growth, which strengthened between 2014 and 2017 – despite the uncertainty resulting from the Brexit vote in June 2016.
UK growth rate and level
The UK’s average trend rate of growth of national income is around 2.2% per year, or roughly 0.5% per quarter. A recession is officially defined as a period of at least two consecutive quarters of negative output growth.