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National income and its measurement: Class 12 Economics
GDP, GNP and NNP, the three methods of measuring national income, nominal and real GDP, per capita income and the circular flow of income.
Key points
National income is the total value of the goods and services produced by the people of a country in a year. It is a measure of the size of the economy and of how well it is growing. Economists use it to compare years, to compare countries and to plan policy.
The main measures are:
- Gross Domestic Product (GDP): the total market value of all final goods and services produced inside a country in a year, by anyone.
- Gross National Product (GNP): GDP plus net factor income from abroad, which is the income that citizens earn from abroad less the income that foreigners earn in the country.
- Net National Product (NNP): GNP minus depreciation, which is the wear and tear of capital goods.
- Per capita income: national income divided by the population.
Only final goods and services are counted, because the value of intermediate goods, such as flour used to make bread, is already included in the price of the final good. Counting both would be double counting. Transfer payments, such as pensions and stipends, and the sale of second hand goods are also not counted, since no new production has taken place.
There are three methods of measuring national income, and they should give the same result:
- The product method adds the value added at each stage of production in all sectors.
- The income method adds the incomes earned by the factors of production: wages, rent, interest and profit.
- The expenditure method adds all spending on final goods and services: GDP = C + I + G + (X - M), where C is consumption, I is investment, G is government spending, X is exports and M is imports.
Nominal GDP is measured at the prices of the current year, so it can rise because prices rise. Real GDP is measured at the prices of a base year, so it shows the change in the quantity of output. The GDP deflator = (nominal GDP / real GDP) x 100, and it is used as a measure of the price level.
The circular flow of income shows how money moves between households and firms. Households supply labour and other factors to firms and receive income. They spend this income on the goods and services of firms. Savings, taxes and imports are leakages from the flow, and investment, government spending and exports are injections into it.
National income figures have limits. They do not count unpaid work at home, a large part of the informal economy may be missing, and they do not show how income is shared. They also give no information on the quality of life, the environment or leisure time, so GDP per capita is not the same as welfare.
Study tip: Write the formula first, label every number with its unit, and say in one sentence what the answer means.
Definitions and flashcards
Say the meaning first, then open the card to check.
GDP
The market value of final goods and services produced inside a country in a year.
GNP
GDP plus net factor income from abroad.
NNP
GNP minus depreciation.
Value added
The value of output less the value of the intermediate goods used.
Double counting
Counting the same output more than once.
Real GDP
GDP measured at constant prices.
GDP deflator
(Nominal GDP / real GDP) x 100.
Leakage
Income that leaves the circular flow, such as savings, taxes and imports.
Formula sheet
| Name | Formula | What it means |
|---|---|---|
| Expenditure method | GDP = C + I + G + (X - M) | Total spending on final goods and services. |
| GNP | GNP = GDP + net factor income from abroad | Income of citizens, wherever it is earned. |
| NNP | NNP = GNP - depreciation | National product after capital wear and tear. |
| GDP deflator | (Nominal GDP / Real GDP) x 100 | Index of the price level. |
Short questions with model answers
These are the kind of questions asked for 2, 3 and 5 marks. Try each one before opening the answer.
Define GDP. (2 marks)
GDP is the total market value of all final goods and services produced inside a country in one year.
Why are only final goods counted in GDP? (3 marks)
The price of a final good already includes the value of the intermediate goods used to make it. If both were counted, the same output would be counted twice, which is called double counting.
Name the three methods of measuring national income. (3 marks)
The product method, which adds value added in each sector. The income method, which adds wages, rent, interest and profit. The expenditure method, which adds consumption, investment, government spending and net exports.
Differentiate between nominal GDP and real GDP. (3 marks)
Nominal GDP is measured at current prices and can rise only because prices rise. Real GDP is measured at the constant prices of a base year, so it shows the true change in output.
Explain the circular flow of income. (5 marks)
Households give labour and other factors to firms and receive wages, rent, interest and profit. They spend this income on the goods and services that firms produce, so money returns to the firms. Savings, taxes and imports are leakages from the flow. Investment, government spending and exports are injections that add to it.
State the limitations of GDP as a measure of welfare. (5 marks)
It leaves out unpaid work at home and much of the informal economy. It does not show how income is shared between rich and poor. It ignores the damage to the environment and the value of leisure. A high GDP per capita does not always mean a high quality of life.
Numericals with worked steps
In an economy C = 600, I = 200, G = 150, exports = 100 and imports = 80 (in billion rupees). Find GDP.
- GDP = C + I + G + (X - M).
- Net exports = 100 - 80 = 20.
- GDP = 600 + 200 + 150 + 20 = 970.
Answer: GDP = Rs. 970 billion.
GDP is Rs. 970 billion, net factor income from abroad is Rs. 30 billion and depreciation is Rs. 50 billion. Find GNP and NNP.
- GNP = GDP + net factor income from abroad = 970 + 30 = 1,000.
- NNP = GNP - depreciation = 1,000 - 50 = 950.
Answer: GNP = Rs. 1,000 billion and NNP = Rs. 950 billion.
Nominal GDP is Rs. 500 billion and real GDP is Rs. 400 billion. Find the GDP deflator.
- GDP deflator = (nominal GDP / real GDP) x 100.
- = (500 / 400) x 100 = 125.
Answer: The GDP deflator is 125, which means prices are 25% higher than in the base year.
Common mistakes
- Counting intermediate goods as well as final goods.
- Including pensions, stipends or second hand sales in GDP.
- Mixing up GDP and GNP. GNP adds net factor income from abroad.
- Forgetting to subtract imports in the expenditure formula.
- Calling nominal GDP growth real growth when prices have risen.