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National Income Accounting and Circular Flow of Income

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 List of Contributors

Nwogwugwu Uche Collins Associate Professor Department of

Economics Nnamdi Azikiwe
Univesrity, Awka

Rev. Sr. Maria C. Uzonwanne Ph.D Lecturer, Department of Economics

Nnamdi Azikiwe Univesrity, Awka

Obi, Kenneth Onyebuchi Associate Professor Department of

Economics Nnamdi Azikiwe
Univesrity, Awka

Ezenekwe, Uju Regina Ph.D Lecturer, Department of Economics

Nnamdi Azikiwe Univesrity, Awka

Chris, Kalu U Lecturer, Department of Economics

Nnamdi Azikiwe Univesrity, Awka

Okeyika, Kenechukwu Okezie Lecturer, Department of Economics

Nnamdi Azikiwe Univesrity, Awka

Maduka Olisaemeka Denis Lecturer, Department of Economics

Nnamdi Azikiwe Univesrity, Awka

Metu, Amaka G. Lecturer, Department of Economics

Nnamdi Azikiwe Univesrity, Awka

Eze, A. Eze Lecturer, Department of Economics

Nnamdi Azikiwe Univesrity, Awka

Nwokoye, Ebele Stella Ph.D\ Senior Lecturer, Department of

Economics Nnamdi Azikiwe
Univesrity, Awka
 CHAPTER ONE
NATIONAL INCOME ACCOUNTING AND CIRCULAR FLOW OF INCOME
Nwogwugwu Uche Collins and Rev. Sr. Maria Chinecherem Uzonwanne
1.1 Introduction
In the early 1930s, it was impossible for macroeconomics to exist in the form we know it
today. This is because, many aggregate concepts had not yet been formulated, or they were lacking
rigour. In the mid-1930s, two Keynesians - Simon Kuznets and Richard Stone began to develop
this terminology. Consequently, they came up with “National Income Accounting”. The national
income accounting is a set of rules and definitions for measuring economic, activity in an aggregate
economy. The Kuznets' national accounts brought tremendous breakthrough in economic analysis
for policy makers and economists alike. For the first time, governments had a framework for
collecting and organizing macroeconomic data mat allowed them to monitor the performance of
their economics. Likewise, Kuznets' national accounting system enabled economists to put various
macroeconomic theories to the test against actual data. It is important to point out here that the
national income accounting system is based on the logic of the circular flow model. As we
developed this model, attempt is made to point out a number of spending and income flows that
must be measured if we are to gauge the extent of macroeconomic activity. In this chapter, we
show how these various spending and income flow relate to one another in the overall economy.
We started by understanding what exactly we mean by national income and output; what people
mean when they refer to GDP and how it differs from GNP. Also, we discussed the measurement
of national output and how by summing the value added for each industry or sector we arrive at a
standard measure of national product; and we also discussed how we can arrive at the same
measure of national output both from the spending side of the economy and from adding up factor
(inputs) incomes. In passing, an explicit result of these discussions is a demonstration of the
equivalence of the concepts of national income and output, finally we discussed the circular flow
of income.
1.2 Concepts in National Income Accounting
To get a clear grasp of what national income accounting is all about certain concepts will
be defined and explained. These concepts include Gross Domestic Product (GDP), Gross National
Product (GNP), Net National Product (NNP), Personal Income (PI) and Disposable Income (DI).
1.3 Gross Domestic Product (GDP)
The main measure of the performance of an economy is the total output of goods and
services, also known as aggregate output. This aggregate output has been labeled Gross Domestic
Product (GDP). In short, Gross Domestic Product is the total market value of all final goods and
services produced in a given year.
The gross domestic product (GDP) measures the value of economic activity within a
country. Strictly defined, GDP is the total market or money value of all the final goods and services
produced in an economy during a given period of time, usually quarterly or a year.
This definition is simple but a lot of subtle issues arise when computing the GDP. We shall bring
our discussion together by considering some key points in this definition, thus there are four
important distinctions within this seemingly simple definition:
I. Market or Money Value - The market prices expressed in monetary terms measure the
amount people are willing to pay for different goods and services so they reflect the value
of these goods and services in local currency.
II. Final Goods and Services - GDP tries to capture all final goods and services as long as
they are produced within the country, thereby assuring that the final monetary value of
everything that is produced in a country is represented in the GDP. In other words,
intermediate goods and services are not included in the GDP because they are used for
further production of goods and services and thus, they are not final goods.
III. Within A Country - GDP measures the market value of all goods and services produced
within a country (i.e. the geographical space of the country). For instance, the production
of an American working in Nigeria is part of the Nigeria's GDP. Also, the product of a
Spanish factory located in Nigeria is part of Nigeria's GDP.
IV. During a Given Period of Time - GDP is calculated for a specific period of time, usually
a year or a quarter of a year.
The Gross Domestic Product (GDP) is often considered the best and most widely used
measure of how well the economy is performing. It measures the value of economic activity within
a country. The GDP measures the total income of everyone in the national economy and the total
expenditure of everyone on the national output of goods and services. This logic is valid because,
for the national economy as a whole, income must equal expenditure.
The reason why the national income is equal to the expenditure is simply that every
economic transaction has two parties - a buyer and a seller. Thus, one man's expenditure is another
man's income. In the simplest sort of the economy, it is assumed that households sell factor services
to firms and thus, earn incomes which they can use to purchase goods and services. In this case,
the household is a seller and the firm is the buyer. On the other hand, firms sell goods and services
to the households and thus, earn revenues which they can use to hire factor services from the
households. In this case, the firm is a seller and the household is a buyer.
Therefore, every money spent by some buyers is money earned by some sellers. In general,
the transaction contributes to the national income and to its expenditure so that the GDP whether
measured as total income or total expenditure becomes identical.
GDP measures the value of the total production attributable to all factors of production that
arc located in the territory of a given country. It is gross due to the fact that provision has not been
made for the consumption of fixed capital used up in the production. The ‘Gross’ in national
account aggregates refers to the fact that we are measuring currently produced outputs or income
without taking into account the wearing out, or depreciation of capital goods during their
production. Thus, the gross value added of the economy as a whole before any allowance for
depreciation, gross domestic product is the nation's output before allowing for depreciation and
the gross national product is the citizens output before allowing for depreciation. This idea is based
on the fact that the fixed assets that are used in production suffer wear and tear and hence, some
replacement costs are made to put the equipment back to live. However, in measuring GDP or
GNP, this replacement cost is not depreciated or deducted.
Gross Domestic Product at market price is when the value of production measured at
market price. Gross Domestic Product at factor cost is when the value of Gross Domestic Product
is at factor cost. The disparity between the two is that GDP at factor excludes the excess of the
indirect taxes over subsidies that may have been levied on the goods and services, while the other
does not. There is one important difference that arises when calculating the level of GDP from the
expenditure side of the economy compared to calculating it by summing up the value added in
production at the price of various factors. The difference arises because the price paid by
consumers (purchasers in the Nigerian Accounts) for many goods and services is not the same
thing as the revenue received by the producers.
There are taxes that have to be paid that make the difference. Such taxes are referred to as
indirect taxes. Examples of Nigeria's indirect taxes include VAT (value added tax), and Excise
duties.
The term Current Factor Cost (Prices) is used in the National Accounts to refer to the
prices of products as received by producers. Market prices are the prices as paid by the consumers.
Thus, current factor costs are equal to market prices minus taxes on products plus subsidies on
products.
Since our final expenditure categories in the national accounts are all measured at market
prices - as they measure what consumers spend rather than what, is received by producers - we can
proceed by adding up these final expenditures to arrive at GDP at market prices directly. To
convert the GDP at factor cost to GDP at market prices in Nigerian national accounts, we add the
difference between indirect taxes and subsidies to the GDP at factor cost.
1.4 Gross National Product (GNP)
Gross National Product (GNP) is defined as the total monetary value of market prices, of
all final goods and services produced in the economy during a year plus the net income abroad.
Net income from abroad is the difference between the residuals of a country got as income from
abroad and income earned by foreigners. In addition, Gross National Product could be referred to
the figure derived after necessary adjustment is made for the surplus of a country on its current
account with the rest of the world. This surplus is the addition of the net export of goods and
services and the net factor incomes received from abroad. Thus, GNP = GDP - M + X, where M
stands for imports and X for exports.
The gross national product (GNP) is another most widely used measure of an economy's
total output. It is a monetary measure and helps also to measure the well-being of a nation's
citizens. Therefore, the gross national product (GNP) is defined as the total market or money value
of all the final goods and services produced by the citizens or permanent residents of a country
(irrespective of their location) during a specific period of time, usually one year. Just like the GDP,
in calculating the GNP of a country, the value of all the final goods and services must be expressed
in monetary terms as this will help to avoid the problem of double counting. Intermediate goods
are normally excluded in the GNP. Also, only the money value of currently produced goods is to
be taken into account. This is because; the GNP measures the productivity of the citizens of a
country within a given period of time. For instance, if some goods were produced in the year 2013
and were not sold till 2014, they would be part of the GNP of 2013 and not 2014.\
1.5 How to Calculate GNP
Table 1.1 below presents a standardized format for the calculation of GNP from both the
flow of product or expenditure and the flow of income or earning.
Table 1.1: Standardized Formats for GNP Calculation
Flow of Income (Earning) Flow of Expenditure (Product)
Land: Rental Income Private Domestic Consumption (C)
+ +
Labour: Wages and Salaries Gross or Net Domestic Investment (I)
+ Supplement to wages and +
salaries Government Consumption Expenditure (G)
+ Proprietor's Income +
+ Other labour income Net Exports: Exports - Imports (X-M)
+ +
Capital: Interest (net interest paid by Net Inventories (goods produced but not
businesses) sold)
+ +
Entrepreneur: Corporate Profit Capital Consumption Allowances (CCA)
Before Tax (CPBT) which include; (added only if Investment is given as Net
(corporate profit tax Investment).
+ dividend
+ retained earnings or
undistributed profit or
company savings).
+
Indirect Business Taxes
+
Business Transfer Payment
+
Unincorporated Income of
Enterprises.
+
Inventory Valuation Adjustment
(added only if there is inflation or
deflation)
+
Statistical Discrepancies
+
 Capital Consumption Allowances
(CCA) which include;
(Depreciation + Accidental Damage
to Business Property).
GNP GNP
NB: CCA = Depreciation + Accidental Damage to Business Property.
Gross Domestic Investment = Net Investment + CCA.
Net Exports = Exports – Imports
When investment is given as Net Investment, then CCA should be added to the expenditure side
of the GNP. On the other hand, when investment is given as Gross Investment, there is no need to
add CCA to the expenditure side of GNP because it already part of the gross investment. However,
CCA is always added to the income side of the GNP.
Net Inventories - Also known as changes in inventories are goods produced especially investment
goods but are not used or consumed.
Retained Earnings - Also known as undistributed profit or company savings are those incomes
which a company do not want to share or the company want to save for future investment.
Inventory Valuation Adjustment – These are changes in the value of goods adjusted for inflation
or deflation:
Statistical Discrepancies - This is an error in the measurement of GNP which is given to ensure
that the GNP balances from both income and expenditure sides.
Worked Example
Given the following hypothetical figures or data for country A for year B with no price inflation
or deflation;
Net private domestic investment - - - - - - 20
Net interest paid by business - - - - - - - 10
Rental income of persons - - - - - - - 10
Indirect business taxes - - - - - - - 35
Corporate profit taxes - - - - - - - - 25
Dividend - - - - - - - - - 10
Interest paid on national debt - - - - - - - 15
Personal consumption expenditure - - - - - - 250
Income of unincorporated businesses - - - - - - 43
Personal income tax - - - - - - - - 35
Government purchases of goods and services - - - - 90
Wages and salaries - - - - - - - - 220
Undistributed corporate profit - - - - - - 10
Social security taxes - - - - - - - - 5
Depreciation - - - - - - - - - 20
Corporate profit before tax - - - - - - - 45
Accidental damage to business property - - - - - 13
Net exports - - - - - - - - - 50
Business transfer payment - - - - - - - 50
Capital gain - - - - - - - - - 20
Shares of GTBank purchased - - - - - - - 10
Flour purchased by Madichie's bakery - - - - - 12
Goods purchased but are not sold - - - - - - 5
Wages accruals over disbursement - - - - - - 20
Statistical discrepancies - - - - - - - 2
Compute GNP from both expenditure and income flow and derive the Net National Product
(NNP), National Income (NI), Personal Income (PI), and Disposable Personal Income (DPI).
Table 1.2: Showing GNP for country A at the end of year B.
Income/Earning Flow Expenditure/Product Flow
Rental income 10 Personal consumption expenditure 250
Wages and salaries 220 Net private domestic investment 20
Net interest paid by business 10 Govt. purchases of goods & services 90
Corporate profit before tax 45 Net export 50
Indirect business taxes 35 Goods produced but are not sold 7
Business transfer payment 50 Capital consumption allowances 33
Unincorporated income of enterprises 45
Statistical discrepancies 2
Capital consumption allowances 33
GNP 450 GNP 450
NNP = GNP - CCA
NNP = 450 - 33 = 417
NI = NNP - Indirect business taxes - Business transfer payment – Statistical discrepancies - Current
surplus of business enterprises + Subsidy NI = 417-35-50-2 = 330
PI = NI - Corporate profit tax - Undistributed profit (retained earnings) - Social security
contribution for social insurance - Excess of wages accruals over disbursement + Dividend (if
not already in the GNP) + Government transfer payment (scholarship/pension) + Private
transfer payment + Consumer interest payment + Business transfer payment + Interest
payment made by government (interest paid on national debt) + Capita/ gain or loss.
PI = 330 – 25 – 10 – 5 – 20 + 50
DPI = PI – Personal income tax.
DPI = 355 – 35 = 320
20 = 355

1.6 GDP vs GNP

If you spend much time listening to politicians or watching financial news programs on TV
or on the internet, you have undoubtedly heard the terms “GDP” and “GNP”. The terms come up
in discussion of the economy or big picture financial matters, and sometimes seem
interchangeable. But what are GDP and GNP, and what is the difference between the two?
 Both represent an attempt to measure the total economic output of a nation during a given
period and serves as barometers to measure both the level and direction of a country's economic
activity. GDP is just one way of measuring the total output of an economy. GNP is another method.
The GDP as defined earlier is the total market value of all me final goods and services produced
within a country. However, the GNP narrows this definition a bit - it is the total market value of
all the final goods and services produced by the permanent residents of a country regardless of
their location.
The important distinction between GDP and GNP rest on differences in counting
production by foreigners in a country and by nationals outside of a country. For the GDP, of a
particular country, production by foreigners within that country is counted and production by
nationals outside of that country is not counted. However, for GNP, production by foreigners
within a particular country is not counted and production by nationals outside of that country is
counted. Thus, while GDP is the value of goods and services produced within a country, GNP is
the value of goods and services produced by citizens, of a country irrespective of their location.
More specifically:
 GDP is calculated either by measuring all incomes earned within a country or by measuring
all expenditures within the country, which should approximately be the same.
 GNP uses GDP, but adds income from foreign sources, less income paid to foreign citizens
and entities. GNP can be .either higher or lower than GDP; depending on whether or not a
country has positive or negative results from net foreign inflows and outflows.
Mathematically, the relationship between GDP and GNP can be expressed as:
GNP = GDP + Net Foreign Incomes (i.e. income from foreign source – income paid to
foreign citizens and entities)
The distinction between GDP and GNP is theoretically important but not often practically
consequential. Since the majority of production within a country is by nationals within that
country, GDP and GNP are usually very close together. However, both GDP and GNP are
complicated, and best summarized in a side-by-side comparison as shown in table 1.3 below:
Table 1.3: GDP vs GNP at a Glance
Question GDP GNP
1. What is it? A measure of the total Same as GDP.
economy of a nation.
2. How is it calculated? By measuring all income GDP plus income from
earned within a country, or foreign source, less income
by measuring all paid to foreign citizens and
expenditures within the entities.
country which should
approximately match.
3. Why is it important? It measures both size and Same as GDP.
direction of economic
activity (growth, stagnation
or contraction) – expansion
and recessions are based on
changes in GDP.
4. Who uses it? Politicians, economists, Same as GDP.
large companies (especially
multinationals).
5. What does it mean to Shows the relative strength Same as GDP.
me? of the nation's economy
compared to that of other
nations, provides a base
from which to measure
economic changes.
6. Per capita GDP/ONP? The GDP of a country The GNP of a country
divided by its population. divided by its population.

1.7 Net National Product (NNP)

Net National Product is the calculation of all incomes accruing to factors of production that
are supplied by inhabitants of a given country over a given period of time, usually a year, after
deducting depreciation but before deduction for direct taxation. By way of calculation, NNP can
be derived thus: GNP - Depreciation. Often times, Net National Product has been referred to as
national income proper.
This is the net output of goods and services within a period of one year. In order to calculate
the NNP, the GNP is depreciated giving a balance of NNP (i.e. NNP = GNP - Depreciation). This
concept is based on the fact that during the course of production, plants and machines suffer wears
and tears and need to be replaced in order to get the NNP, the cost of replacement must depreciated.
This system is superior to the concept of GNP as it gives room for depreciation during the
year. It has the advantage of giving a better picture of the performance of the economy (i.e. increase
or decrease in production). However, it has the problem of deciding what rate should be used for
depreciation of the machines and equipment.
NNP at Factor Cost - This, also known as the national income is the aggregate of all the goods
and services produced within a period of one year with the cooperation of all the factors of
production at factor costs. The factor costs include receipts or income to these factors in the form
of wages and salaries, rents, interests and profits.
Personal Income (PI)
Personal Income (PI) refers to the quantity of national income that is received by individuals. It
may be described as the income received by individuals of a country as rewards for their
contributions in the economy within a period of one year. The sum of the personal incomes is
never equal to the national income because personal income includes transfer payments whereas
transfer payments are deducted from national income.
In order to derive the personal income from national income, those amounts which are not
available for distribution to the factors of production are to be deducted.
Personal income = national income – corporate income tax – undistributed corporate profits –
social security contributions + transfer payments.
Disposable Income (DI)
Disposable Income (DI) is the income from all sources, which accrues to individuals and
households after deducting direct taxes and other transfers to them. It is that while individuals
engage in one economic activity or the other, they contribute to the national output and by so
doing; they receive rewards (i.e. personal income). However, the whole of the personal income is
not available to the individual for consumption. A given ratio of the personal income is paid to the
government in the form of direct tax and the rest is left for the individual. This is called the
disposable personal income (i.e. income left for an individual after tax has been deducted). It is
normally obtained by deducting direct taxes and other transfers from personal income. It follows
then that disposable income is smaller than personal income. Disposable personal income =
personal income – personal income tax. However, the whole of the disposable income is not spent
on consumption, some are saved. Therefore; Disposable income = consumption + saving.
1.8 Method of Measuring National Income: Output, Income and Expenditure Methods.
Measuring the National Income
Every household, business outfits and even the .government as well as other economic
decision making units keeps tracks of their income and expenditures. This record is usually done
on a daily, weekly, monthly, and even on a yearly basis for transaction which of course reveals
their incomes and expenditures. In a likewise manner, every nation keeps track of output in the
country and the income generated by and for its people.
The measure of national income and national output or product that are used in Nigeria and
other countries are derived from an accounting system that has been standardized by international
agreement and is thus common to most countries of the world. This is known as the International
System of National Accounts. These accounts have a logical structure, based on the simple yet
important idea that all output must be owned by someone. In other words, whenever the national
output is produced, it must generate an equivalent amount of claims to that output in the form of
national income.
Corresponding to the two halves of the circular flow are two ways of measuring national
income: by determining the value of what is produced and by determining the value of the income
claims, generated by production. Both measures yield the same total which is called gross,
domestic product (GDP). When it is calculated by adding up the total spending for each of the
main components of final output, the result is called GDP expenditure or spending approach.
However, when it is calculated by adding up all the incomes generated by the act of production, it
is called GDP income earning approach.
The table 1.4 below presents the Nigeria 2010 account (the last detailed measurement of
gross domestic product of Nigeria available as a standard publication). The Nigerian National
Income Economists present two accounts – GDP expenditure approach as labeled "Gross Domestic
Product and Expenditures" and the GDP income approach as labeled "Gross Domestic Product".
Table 1.4: Gross Domestic Product and Expenditure at 1990 constant Purchaser's Prices (N'
Million)
Components 2010
Government Final Consumption 254,066.99
Expenditure
Private Consumption Expenditure 193,677.66
Increase in Stocks 102.65
Gross Fixed Capital Formation 77,438.02
Exports of Goods and Services 235,242.40
Less Imports of Goods and Services 149,966.68
GDP by Expenditure 610,561.05
Compensation of Employees 19,882.22
Operating Surplus 568,674.26
Consumption of Fixed Capital 5,224.96
Indirect Taxes 17,168.22
Less Subsidies 388.62
GDP by Income 610,561.05
Source: CBN Statistical Bulletin, 2010.
1.9 Methods of Estimating National Income (GPP/GNP)
Conventionally, there are two distinct methods of estimating national income: GDP/GNP
expenditure or product approach and GDP/GNP income or earning approach. These approaches to
the GDP/GNP estimation is built on the logic that all value produced must be accounted for by a
claim that someone has to that value. For instance, any spending one make when one buy a TV set
must also be received by the supplier of that TV set. Therefore, the value of what one spends is
the expenditure or spending, and the value of the product sold to one is the output. Thus, the two
values calculated on income and expenditure bases are identical conceptually, and differs in
practice only because of errors of measurement. However, any discrepancy arising from such
errors is then reconciled so that one common total is given as the measure of GDP/GNP. Both
calculations are of interest because each gives a different and useful breakdown. Also, having two
independent ways of measuring the same quantity provides a useful check on statistical procedures
and on unavoidable errors in measurement. However, there is another method of estimating
GDP/GNP, this is known as the "Value Added" or output approach. We shall discuss these
approaches in detail in subsequent sections.
GDP/GNP Expenditure Approach
This approach, also known as the GDP/GNP spending-based for a given year is calculated by
adding up the spending going to purchase the final output produced in that year. Total spending
on final output is expressed in the national accounts as the sum of three broad categories of
spending: consumption investment and net exports. However, consumption is further divided into
government consumption and that of private individuals (and non-profit organisations serving
households). Hence, there are four important categories of spending that we will discuss in
considerable detail – private consumption, government consumption, investment and net exports.
Here, we define what these spending categories are and how they are measured. Throughout, it is
important to remember that they are exhaustive they are defined in such a way that all spending
on final output fall into one of the four categories.
Private Consumption Expenditure - Private consumption expenditure includes spending by
individuals on goods and services produced and sold to their final users during the year. It includes
services such as haircut, medical care and legal advice, non-durable goods, such as fresh meat,
clothing, cut flowers, and fresh vegetables and durable goods such as cars, television sets and
microwave ovens. However, it excludes purchase of newly built houses as these are counted as
investment. Also recorded in national account as part of private consumption, is the final
consumption spending of non-profit making institutions serving households. These are charitable
institutions that are neither for profit-making nor for the government but do contribute some
spending and so have to be included somewhere in the national accounts. However, we denote
actual, measured, private consumption spending by the letter ‘C’.
Government Consumption Spending – When government provide goods and services that their
citizens want, such as health care and street lighting, it is obvious that they are adding to the sum
total of valuable output in the same way as do private firms that produce cars and video cassettes.
With other government activities, the case may not seem so clear. Should spending by the Nigerian
government to negotiate over the security situation in the North, or to pay a civil servant to help
draft legislation, be regarded as contribution to the national product? Some people believe that
many (or even most) activities in town halls are wasteful, if not downright harmful. Others believe
that governments produce many of the important things of life, such as education, law and order,
and pollution control.
Investment Spending – investment spending as refer to as private investment or private domestic
investment is defined as spending on the production of goods not for present consumption but
rather for future use. The goods that arc created by this spending are called investment (or capital)
goods. Investment spending can be divided into three categories – change in inventories, fixed
capital formation and the net acquisition of valuables. Changes in inventories – are the stock of
inputs and unfinished materials which firms keep that allow them to maintain a steady stream of
production in the event of short run fluctuations in the deliveries of inputs bought from other firms.
These stocks of inputs and unfinished goods are counted as current investment because they
represent goods produced (even if only half-finished) but not used for current consumption.
Inventories are valued at what they will be worth on the market, rather than at what they have cost
the firm so far. This is because the expenditure-based measure of GDP/GNP includes the value of
what final spending on these goods would be if they were sold, even though they have not been
sold yet. Fixed capital formation - are manufactured aids to production such as machines,
computers, and factory buildings. Creating new capital goods is an act of investment and is called
fixed investment or fixed capital formation. The economy's total quantity of capital goods is called
the capital stock. Also, housing construction is counted as investment spending rather than as
consumption spending. However, when a family purchases a house from a builder or another
owner, the ownership of an already produced asset is transferred, and that transaction is not part
of current GDP/GNP. Net acquisition of valuables - some productive activity creates goods that
arc neither consumed nor used in the production process. Rather, they are held for their intrinsic
beauty or for then-expected appreciation in value. For instance, jewellery and other works of art
are typical examples as they are known as valuables. Acquisition less disposal of valuables is
treated as investments in the national accounts.
Gross and Net investment - total investment spending is called gross investment or gross capital
formation. Gross investment is divided into two parts – replacement investment and net
investment. Replacement investment is the amount of investment that just maintains the level of
existing capital stock. In other words, it replaces the bits that have worn out. Also, replacement
investment is classified as the "capital consumption allowances" or simply depreciation. Thus,
gross investment minus replacement investment is net investment. Mathematically, gross
investment = net investment + depreciation. Positive net investment increases the economy's total
stock of capital while replacement investment keeps the existing stock intact by replacing what
has been used up or worn out. All of gross investment is included in the calculation of GDP/GNP.
This is because all investment goods are part of the nation's total output and their production
creates income (and employment) whether the goods produced are a part of net investment or are
merely replacement investment. Actual total investment spending is denoted by the letter T.
Net Exports - The fourth category of aggregate spending and one that is very important to every
economy arises from foreign trade. How do imports and exports affect the calculation of
GDP/GNP?
Imports - A country’s GDP is the total value of final goods and services produced in that country.
If one spend N10,000 on a phone that was made in China, only a small part of that value will
represent spending on Nigeria production. Some of it represents payment for the services of the
Chinese dealer and for transportation within this country; much of the rest is the output of Chinese
products, though there may be component suppliers from several countries. Also, if you take your
next holiday in UK, much of your spending will be on goods and services produced in UK and
thus, will contribute to UK GDP. Similarly, when a Nigerian firm makes an investment
expenditure on a Nigeria-produced machine tool that was made partly with imported materials,
only part of the spending is on Nigeria production; the rest is on production by the countries
supplying the materials. However, the same is true for government spending on such things as
roads and dams; some of the spending is for imported materials, and only part of it is for
domestically produced goods and services. Whether private consumption, government
consumption, and investment, all have import content. To arrive at total spending on Nigeria
output, we need to subtract from total Nigeria resident's spending the actual spending on imports
of goods and services, which is represented by the letter" 'M'.
Exports – If Nigerian firms sell goods or services to Chinese consumers, the goods and services
are a part of Chinese consumption spending, but they also constitute spending on Nigerian output.
Indeed, all goods and services that are produced in Nigeria and sold to foreigners must be counted
as part of Nigerian GDP because they are produced in Nigeria, and thus, creates incomes for the
Nigerian residents who produce them. However, these goods or services are not purchased by the
Nigerian residents, so they are not included as part of C, I, or G. Therefore, to arrive at the total
value of spending on the domestic product, it is necessary to add the value of exports. Exports are
represented with the letter 'X'.
In general, it is convenient to group exports and imports together as net exports. Therefore, net
exports is defined as total exports of goods and services minus total imports of goods and services
(X - M), also denoted by 'NX'. When the value of exports exceeds the value of imports, the net
exports term is positive. When the value of imports is greater than the value of exports, the net
exports term is negative.
Total Spending – The GDP spending-based is therefore the sum of private consumption,
government consumption, investment, and net exports spending on currently produced goods and
services. It is GDP at .market prices. Mathematically;
GDP/GNP Income Approach
The production of a nation's output generates income. Labour must be employed, land must be
rented, and capital must be used. The calculation of GDP/GNP from the income side involves
adding up factor incomes so that all of that value is accounted for. In essence, we are taking the
value added displayed for the economy as a whole and dividing this up by types of income rather
than by industrial sector (or kind of economic activity). We have already noted that all value
produced must be owned by someone, the value of production must equal (he value of income
claims generated by that production. National income accountants distinguish four main categories
of factor incomes: operating surplus, compensation of employees, consumption of fixed capital,
and indirect taxes less subsidies. Table 4.1 presents the GDP income approach for Nigeria in 2010
as the “Domestic Product” part of the table.
Operating Surplus - Operating surplus are net business incomes after payment has been made to
hired labour and for material inputs but before direct taxes (such as company tax) have been paid.
Operating surpluses are in large part profits of firms, but also included is the financial surplus of
organization other than companies such as universities. Both distributed and undistributed profits
are included in the calculation of GDP/GNP.
Compensation of Employees – This is wages and salaries (usually just referred to as wages). It is
the payment for the services of labour. In total, wages represent that part of the value of production
that is attributable to hired labour.
Consumption of Fixed Capital – This is represented by net interest payments. Net interest
includes interest earned by households and governments minus interest paid by households and
governments. That is, interest paid by households and governments is excluded from the
GDP/GNP because not all borrowing by government and consumers is for the acquisition of capital
assets as schools, highways, automobiles, and household goods. So the market provides no
measure of the return on their investment compared to the market-determined measure of return
on the business concerns investment that can be included in GDP/GNP (Note that households
getting returns on investments are referred to as "unincorporated business enterprises" in the
National Accounts).
Indirect Taxes Less Subsidies – Subsidies and transfer payments are payments (including
charitable contributions, bad debts) by the government and business sector to the household for
which no current productive services are rendered. Hence, they are not included in the GDP/GNP.
However, they are receipts of the household sector and therefore are included in personal income.
Income Produced and Income Received
GDP at market prices provides a good measure of total output produced in a country (say Nigeria),
and total income generated as a result of that production. However, the total incomes received by
Nigerians differ from GDP for two reasons. First, some domestic production creates factor
earnings for non-residents who either do some paid work for Nigerian residents or have previously
invested in Nigeria; on this account, the income received by Nigeria citizens will be less than
Nigerian GDP. Secondly, many Nigerian citizens earn income from work for foreign nationals or
on overseas investments; on this account, income received by Nigerian residents will be greater
than GDP. While GDP measures the output and hence the income that is produced in this country,
the national income (NI) in the Nigerian National Accounts measures the income that is received
by this country. Therefore, to convert GDP into NI (national income) at market prices, it is
necessary to add the following three terms which combine to make the difference between the
income received by this country and the income produced in this country.
(1) Net factor income from abroad (positive or negative value)
(2) Consumption of fixed capital (negative value).
(3) Net direct business taxes (positive or negative).
Net factor income from abroad: This term is employees' compensation receipts from the rest of
the world minus payments to the rest of the world. It includes property and entrepreneurial income
receipts from the rest of the world minus payments to the rest of the world. This item has been
producing negative value in the Nigerian accounts and so it has constituted a reduction in GDP.
Consumption of fixed capital: The second term is the estimate of the depreciation of the nation's
capital stock. It is always a reduction in the GDP.
Net direct business taxes: It means (add) net taxes on production from the rest of the world
(minus) subsidies given to the rest of the world. The logic behind this is that we are measuring
National Income at market prices. If some element of the market prices paid is a tax that generates
revenue for a foreign government, then that tax represents a loss of income for the domestic
economy as a whole, and reduces domestic gross national income. On the other hand, if it generates
income for us, then that tax represents a gain for us.
GDP/GNP Value Added or Output Approach
The most common method of measuring the national income is the value added or output approach.
It measures the total output of goods and services. The reason why getting a total for the nation's
output is not straightforward as it may seem at first sight is that one firm's output may be another
firm's input. A maker of clothing buys cloth from a textile manufacturer and buttons, zips, thread,
pins, hangers, etc. from a range of other producers. Most modern manufactured products have
many ready-made inputs. A car or aircraft manufacturer for example, has hundreds of component
suppliers. Hence, production occurs in stages such that some firms produce outputs that are used
as inputs by other firms, and these other firms in turn, produces outputs that are used as inputs by
yet other firms.
If we merely add up the market values of all outputs of all firms, we would obtain a total
that was greatly in excess of the value of the economy's actual output. The error that would arise
in estimating the nation's output by adding all sales of all firms is called "Double Counting". This
is so because, if we add up the values of all sales, the same output would be counted every time it
was sold from one firm to another.
The problem of double counting is solved by distinguishing between two types of output.
Intermediate goods and services are the output of some firms that are in turn inputs for other firms.
Final goods and services are goods that are not used as inputs by other firms in the period of time
under consideration. The term final demand refers to the purchase of final goods and services for
consumption, for investment (including inventory accumulation), for use by governments, and for
exports. It does not include goods and services that are purchased by firms and used as inputs for
producing other goods and services.
If the sales of firms could be readily separated into sales for final use and sales for further
processing by other firms, measuring total output would still be straightforward. Total output
would equal the value of all final goods and services produced by firms excluding all intermediate
goods and services. However, when a petrol maker sells petrol to Vaseline company, it does not
care and usually does not know whether the petrol is for final use (say, powering of generator) or
for use as an intermediate good in the production of Vaseline.
Avoidance of Double Counting
The problem of double counting must be resolved in some manner. To avoid double counting,
statisticians use the important concept of value added. Each firm's value added is the value of its
output minus the value of inputs that it purchased from other firms (which were in turn the outputs
of those other firms). Thus, a steel mill's value added is the value of its output minus the value of
the ore that it buys from the mining company, the value of the electricity and fuel oil that it uses,
and the value of all other inputs that it buys from other firms. A bakery's value added is the value
of the bread and cake it produces minus the value of the flour and other inputs that it buys from
other firms.
The total value of a firm's output is the gross value of its output. The firm's value added is
the net value of its output. It is this latter figure that is the firm's contribution to the nation's total
output. It is what its own efforts add to the value of what it takes in as inputs.
Problems Arising from National Income Measurement
We have seen the various ways of estimating the national income. Obviously, this calculation is
tedious principally because of poor and unreliable data from the different sectors of the economy.
These problems take different forms and shapes according to the level of economic development
of different countries. In the advanced countries, the problems are less as a result of high level of
statistical technique. However, in the third world countries, lack of reliable data and low level of
education have continued to heighten the intensity of the problems. These problems include:
 1. Unreliable Data – There is both insufficient as well as unreliable data especially in the
developing countries. Thus, it becomes difficult to calculate agricultural output as well as
correct cost of production in such economies.
2. Income Earned through Illegal Means – Some people engage in illegal business such as
cross boarder trafficking as a source of livelihood. Such people earn income from such
illegal business but their income is not added to the national income where such goods have
value and meet the needs of the consumers. Since they are not added to the national income,
the national income becomes less than the actual.
3. Non-Monetized Sector – Substantial part of what is produced in the developing countries
do not reach the market. Sometimes these are consumed at home without monetary values
attached to them. This makes it difficult to calculate national income correctly.
4. Double Counting – The issue of double counting is a very serious one. Sometimes it
becomes difficult to determine what arc intermediate goods and final goods. Thus, national
income estimate are sometimes feared to be overestimated.
5. Illiteracy and Ignorance - The combine problem of illiteracy and ignorance makes it
difficult for small and medium scale farmers to keep records of their costs and income
levels correctly. To this extent, the efficacy of the national income estimate is limited.
6. Monetary Concept - Since national income is always measured in monetary terms, it
becomes difficult to calculate the value of such goods and services like painting as a hobby
by an individual or taking care of children by their mothers. By excluding such services
from the national income, the results' tend to be less than the actual.
7. Changes in Price - Fluctuation in prices affect the calculation of national income. With
frequent changes in prices, the monetary value of goods and services changes and this
affect the singular measuring rod of national income.
1.11 Determinants and Uses of National Income Statistics
Determinants of National Income Statistics
There are many determinants or factors which influence the size of the national income.
They are as follows:
(i). The stock of factors of production: One of the very important factors which influence
the size of the national income is the quality and quantity of the country's stock of factors
of production. The factors of production include land, labor, capital and entrepreneurship.
Land, for instance, supplies man with gifts of nature and raw material for production. The
production of land depends upon factors like fertility of the soil, latitude, climate and
irrigation system in the country. If these factors are lacking or inadequate, the size of the
national income will be quite small, and vice versa. The quantity of labour has double
influence since labour is both a factor of production as well as the consumer of what is
produced. The quality of labour depends upon intelligence, training, which in turn decides
the volume of industrial productivity. This will have decisive influence on output. For
capital, if what makes up capital is mainly primitive, the size of the national income cannot
be large. But if it is modern, that is to say, modern types of plants are mainly used for
production, then they can enhance the productive capacity of a country. Likewise, the
quantity and quality of entrepreneurship or managerial ability is also a main constituent in
the determination of national income.
(ii). State of technical knowledge: State of technical knowledge is also one of the very
important factors which influence the size of the national income. The extent of technical
know-how and technology in production determine the capital formation in the country. A
country with vast resources will be undeveloped without any determination if the resources
are not technically exploited. Natural resources combined with advanced technology will
go a long way in augmenting the size of national income.
(iii). Political Stability: Political instability greatly impedes economic progress. If there is
political stability in the country, the production can be sustained at the highest level. The
size of the national income will be large. In case of political instability, the production will
be adversely affected and so the size of the national income will be small.
The Uses of National Income Statistics
Generally, national income statistics help governments in planning, policy-making, preparing of
budgets and forecasting the level of economic activity. Specifically, the following are its uses:
(i). National income statistics are important instruments of economic analysis and acts as a
guide to economic policies to be pursued.
(ii). It gives an idea of the structure of the economy; helping to make inter-sectoral comparisons
and studying the rate of growth of the economy.
(iii). It aids to study inter-sectoral growth
(iv). It enables us to study per capita income or per capita consumption which are general
indicators of economic growth
(v). It enables us to make international comparisons of standard of living of people.
(vi). It shows the capacity of a country to bear some common burden of international institutions
like the U.N.O.
1.12 Concept of National Circular Flow of Income
The national circular flow of income is a neoclassical economic model showing how money flows
in the economy. The economy, in the simplest version, has been represented as consisting only of
households and firms. Money flows to workers in the form of wages, and flows back to firms in
exchange for products. The circular flow of income model illustrates the interdependencies of
different sectors in the economy. The national circular flow of income implies a complex,
interconnected web of decision making and economic activity involving business firms and
households. It involves a counterclockwise real flow of economic resources and finished goods
and services, and a clockwise money flow of income and consumption expenditures.
1.13 The Circular Flow of Income without Government, with Government and with
Foreign Sector
Let us make in-depth study of the circular flow of income in an economy without
Government, with Government and with Foreign Sector.
 Figure 1.1: Circular Flow of Income in a Simple Two Sector Economy Source; Subho
(2016)
From the diagram above, factors of production such as land, capital and entrepreneurial
ability flow from households to business firms as indicated by the arrow mark. In opposite
direction to this, money flows from business firms to the households as factor payments such as
wages, rent, interest and profits.
For circular income flow in an economy without government or a two sector economy,
money flows from households to firms as consumption expenditure made by the households on
the goods and services produced by the firms, also there is the flow of goods and services is in
opposite direction from business firms to households.
As money flows from business firms to households in form of factor payments so also,
does it flow from households to firms. Thus there is, in fact, a circular flow of money or income.
This circular flow of money will continue indefinitely week by week and year by year but not
always in the same volume. This is how the economy functions.
This is so because the flow of money is a measure of national income and will, therefore,
change with changes in the national income. In year of recession, when national income is low,
the volume of the flow of money will be small and in years of growth when the level of national
income is quite high, the flow of money will be large.
Certain assumptions hold sway in a two sector economy in order to make our analysis
simple, it is assumed that neither the households save from their incomes, nor the firms save from
their profits. Also, it is assumed that the government does not play any part in the national
economy. Finally, it is assumed that the economy in question is a closed one which neither imports
goods and services, nor exports anything. In fact, we have made clear above the flow of money
that occurs in the functioning of a closed economy with no savings and no role of government. So
far, in our analysis of the circular flow of income in a two sector economy, we have assumed that
all income which the households receive, they spend it on consumer goods and services. A
situation that spirals on. We will now examine the situation when the households save a part of
their income, how s. their savings will affect money flows in the economy.
 When households save, their expenditure on goods and services will reduce to that extent
money flowing to the business firms will contract. With reduced money receipts, firms will hire
fewer workers or retrench some workers in order to reduce the factor payments they make to the
suppliers of factors such as workers. This will lead to the decline in total incomes of the
households. Thus, savings reduce the flow of money payments to the business firms and will cause
a fall in economy's total income. Savings therefore, seen as a leakage from the money expenditure
flow. But savings done by households need not lead to reduced aggregate spending and income if
they find their way back into flow of expenditure. These savings are deposited in financial
institutions such as banks, insurance companies, financial houses, stock markets, especially in a
free market economy. It is further assumed that there are no inter-households borrowings. This
assumption is important in that it allows for borrowings from the financial institutions by business
firms for investment in capital goods such as machines, factories, tools and instruments, trucks.
Firms spend on investment in order to develop their productive capacity in future.
Thus, through investment expenditure by borrowing the savings of the households
deposited in financial institutions, are again brought into the expenditure stream and as a result
total flow of spending does not decline. At this juncture, the question arises what is the condition
for the flow of money income to continue at a steady level so that it makes possible the production
and subsequent flow of a given volume of goods and services at constant prices. To explain this
we have to introduce saving and investment in the analysis of circular flow of income.
At this juncture, let's have a deeper look at saving and investment already introduced in the
analysis of circular flow of income. By saving, one means a part of income that is not spent on
consumer goods and services; a withdrawal of some money from the income flow. By investment,
one means money (savings) spent on buying new capital goods to expand production capacity.
That is to say, while saving is a leakage of some money in circular flow of income, investment is
injection of some money in circular flow of income. For the circular flow of income to go on
unabated, the leaking of money from the income stream by way of saving must equal the injection
of money by way of investment expenditure. Therefore, planned savings must be equal to planned
investment if the constant money income flow in an economy is to be obtained.
If the equality between planned savings and planned investment is disturbed by increase in
planned savings or decrease in planned investment, there will be fall in income, output,
employment and prices, which will make the flow of money to contract. On the other hand, if the
equality between planned savings and planned investment is disturbed by the increase in planned
investment and a decrease in planned savings, there will be increase in income, output and
employment, which will make the flow of money income to expand. It is thus clear from the above
analysis that the flow of money income will continue at a steady level only where the condition of
equality between planned saving and investment is met. Important to note here is the rate of
interest, which is the price for the use of savings determined by saving and investment. If savings
exceed investment expenditure rate of interest falls so that, at a lower rate of interest, investment
increases and both become equal. On the contrary, if investment expenditure is greater than
savings, rate of interest will rise so that at a higher rate of interest, savings increase and become
equal to planned investment expenditure
In national income accounts, savings are identical or always equal to investment especially
in a simple two sector economy where there are no roles of government and foreign trade. This is
a basic identity in national income accounts which needs to be carefully understood. In national
income accounts, we are concerned with actual saving and actual investment and not with planned
saving and planned investment. It is these actual saving and investment that are identical in national
income accounts. We can prove their identity in the following way. In a simple economy which
has neither government, nor foreign trade, the value of output produced which we denote by Y is
equal to the value of output sold. Since the value of output sold in a simple two sector economy is
equal to the sum of consumption expenditure and investment expenditure we have Y = C + I where
Y = Value of aggregate output, C = Consumption expenditure and I = Investment expenditure.
One may ask what happens to the unsold output. The unsold output brings about an increase
in the inventories of goods and in national income accounting, an increase in inventories of goods
is treated as a part of actual investment. This may be considered as the firms selling the goods to
themselves to add to their inventories. Thus, gross national product (GNP) produced is used either
for consumption or for investment. Now, look at the gross national product or income in the simple
economy from the viewpoint of its allocation between consumption and saving. Since national
income (which is equal to GNP) can be either consumed or saved. We have Y = C + S.
From the identities (i) and (ii) we get
C+I=Y=C+S
The left hand side of the identity (iii), namely C + I = Y shows the components of aggregate
demand (that is, aggregate expenditure on goods and services produced) and the right-hand side
of the identity (iii) namely Y = C + S shows the allocation of national income to cither consumption
or saving. Thus, the identity (iii) shows that the value of output produced or sold is equal to the
total income received. It is income received that is spent on goods and services produced.
Now subtracting the consumption (C) from both sides of the identity (iii) we have
I=Y=S
Or I = S
Thus, in our two sector simple economy with neither government, nor foreign trade, investment is
identically equal to saving.

Figure ) 1.2 : Circular Income Flow Model with Government ' Source; Subho (2016)
 Government purchases goods and services just as households and firms do. Government
expenditure may be financed through taxes, out of assets or by borrowing. The money flows from
households and business firms to the government in the form of tax payments. This money flow
includes all the tax payments made by households less transfer payments received from the
Government. Transfer payments are treated as negative tax payments.
Another method of financing Government expenditure is borrowing from the financial
institutions. This can be represented by the money flow from the financial institutions to the
Government. This is known as Government borrowing. Government borrowing increases the
demand for credit, which causes rate of interest to rise. The government borrowing through its
influence on the rate of interest affects the behaviour of firms and households. Business firms see
the interest rate as the cost of borrowing and an increase in the interest rate as a result of borrowing
by the Government lowers private investment. Nonetheless, households who view the rate of
interest as a return on savings will be spurred to save more.
It follows from above that the inclusion of the Government sector significantly affects the
overall economic situation. Total expenditure (low in the economy is now the sum of Consumption
expenditure (denoted by C), Investment expenditure (I) and Government expenditure (denoted by
G). Thus Total expenditure (E) = C + I + G ... (i)
Total income (K) received is allocated to consumption (C), savings (S) and taxes (T). Thus
Y = C + S + T... (ii)
Since expenditure) made must be equal to the income received (Y), from equations (i) and (ii)
above we have
C + I + G = C + S + T ... (iii).
Since C occurs on both sides of the equation (iii) and will therefore be cancelled out, we have
I + G = S + T ... (iv).
By rearranging we obtain
G - T = S - I … (v)
Equation (v) is very significant as it shows what would be the effects if government budget is not
balanced, that is, if Government expenditure (G) is greater than the tax revenue (T), that is, G > T,
the government will have a deficit budget. To finance the deficit budget, the Government will
borrow from the financial institutions.
For this purpose, then private investment by business firms must be less than the savings of the
households. Thus Government borrowing reduces private investment in the economy. In other
words, Government borrowing crowds out private investment.
Figure 1.3: Circular Flow of Income in an Open Economy wills Government and Foreign Sectors
Source: Subho {2016). .
Here, we explain the money flows that occur when a foreign sector is included. The
inclusion of the foreign sector will show to us the interaction of the domestic economy with foreign
countries. Foreigners interact with the domestic firms and households through exports and imports
of goods and services as well as through borrowing and lending operations through financial
market. There is flow of money spending when importing from the domestic business firms to the
foreign countries (i.e., rest of the world). On the contrary, there is also a flow of money spending
on exports from foreign countries to the business firms of a domestic economy.
If exports are equal to the imports, then there exists a balance of trade. Generally, exports
and imports are not equal to each other. If value of exports exceeds the value of imports, trade
surplus occurs. On the other hand, if value of imports exceeds the value of exports of a country,
trade deficit occurs. In the open economy, there is interaction between countries not only through
exports and imports of goods and services but also through borrowing and lending funds or what
is also called international financial market. When there is a trade surplus in the economy, that is,
when exports (X) exceed imports (M), net capital inflow will take place. By net capital inflow, it
is meant that foreigners will borrow from domestic savers to finance their purchases of domestic
exports. In this way as a result of net capital inflow, domestic savers will lend to foreigners, that
is, acquire foreign financial assets.
On the contrary, in case of import surplus, that is, when imports are greater than exports,
trade deficit will occur. Therefore, in case of trade deficit, domestic consumer households and
business firms will borrow from abroad to finance their excess of imports over exports. As a result,
foreigners will acquire domestic financial assets. From the circular flows that occur in the open
economy, the national income must be measured by aggregate expenditure that includes net
exports, that is, X - M where X represents exports and M represents imports. Imports must be
subtracted from the total spending on foreign produced goods and services to derive the value of
net exports. Thus, in the open economy,
National Income = C + I + G + NX
 Where NX represents net exports, X - M,
Since national income can be either consumed, saved or paid as taxes to the Government we have
C + I + G + NX = C + S + T
1.14 The Concept of Aggregate Savings and Aggregate Demand (Consumption and
Investment)
Savings
People do not always wish to spend all their income on consumption. In fact, they normally set
aside a part of their income which will be saved. In other words, one can say that income is
disposed of in two ways: (i) spent on goods and services (consumption) and (ii) kept for a later
date (savings). Mathematically, we can say that disposable income (Y) is made up of consumption
spending (C) and the amount available for savings, i.e. Y = C + S.
From the foregoing definition, we can see that what is not consumed is saved, it then
follows that the saving function is only the mirror image of the consumption function. It also means
that the sum of the average propensity to consume and the average propensity to save would be
unity. On the same vein, the sum of the marginal propensity to consume and the marginal
propensity to save would be one.
ΔYd = AC + AS
Or
ΔC/ΔYd + ΔS/ΔYd = 1
Where
ΔC = Change in consumption
ΔYd = Disposable income
ΔS = Change in savings
Thus, if the empirical value of MFC is 0.7, that of the MRS becomes 0.3. While aggregate saving
is the sum total of the amount of money saved by individual households.
Consumption
When a family receives income, it spends the income on consumption goods like food, clothing,
shelter and other needs, and keeps what remains from the income after meeting these current needs.
Put differently, a family can spend its income on consumption or savings. Putting it in an equation,
it becomes: Y= C + I (Where Y stands for income. C for consumption and I for investment.)
Families generally spend their incomes on necessities of life but as their incomes increase,
expenditure on many consumption goods increases. However, with lime there will be limits to the
extra money people will spend on these goods when their incomes rise. Statistically, many attempts
have been made to find the precise form of relationship between income and consumption. In
general, it has been established that every increment to income involves a constant increment to
consumption.
The constant proportion of additional income that will be consumed is called the marginal
propensity to consume (MFC). It is called marginal because it applies only to additions to income.
Consumption refers to household consumption over a given period of time. Household
consumption could either be autonomous or induced. By autonomous consumption, one refers to
consumption one makes regardless of the amount of income, hence, even if income is zero, the
autonomous consumption would be the total consumption. By induced consumption, one refers to
the level of consumption dependent on the level of income. That said, on a macro level, interest is
on aggregate consumption, which is a sum total of all households' consumption. This is so because
aggregate consumption determines aggregate saving, because saving is defined as part of income
not consumed. Another is, consumption spending accounts for most of national output.
Investment
Saving is normally done by different people and for different reasons. Whatever the reason for or
motivation to save or the individual, it has little to do with the investment opportunities of business
and society. That is to say, even when there are no real investment opportunities, an individual
may still wish to save. However, the availability of individual and household savings in the bank
will encourage firms to borrow and invest. Banks, as we know, depending on the interest rates that
accrue from loans will make funds available for such investment. This presents two situations.
First, the higher the interest rate, the more funds are made available by the hanks to the investors.
Second, the lower the interest rate, the more loans the investors want. The process will continue
until all savings are invested.
Coming under review at this point is the interaction of savings and investment. The saving
function shows that at a higher interest rate, individuals would be more willing to forego their
consumption and save more. This action will affect the level of output of goods and services, since
less and less of them are now being purchased. The level of investment will, eventually, fall. For
equilibrium, savings must equal to an investment. Putting it in equation we have:
Y=C+I
Y=C+S
Therefore, S = I
Aggregate expenditure is normally derived from all the components of aggregate demand, which
investment is among. Aggregate investment is the sum total of the amount of money individual
firms chose to invest on capital goods. By aggregate demand, one refers to the sum total of goods
that are demanded in an economy over a period and thus, aggregate demand is normally defined
by the planned total expenditure in an economy for a given price level.

REVISION QUESTIONS
1. What is circular flow of income?
2. Explain with an illustration a circular income flow in an economy with no government.
3. Explain with an illustration a circular income flow in an economy with government.
4. Explain with an illustration a circular income flow in an economy with government and
foreign sector.
5. Briefly explain the following concepts: savings, consumption and investment.
6. Explain the following:
i. Gross National Product (GNP)
 ii. Gross Domestic Product (GDP)
iii. Net National Product (NNP)
iv. Personal Income (PI)
v. Disposable Income (DI)
7. What are the methods of estimating national income?
8. What possible-problems could arise from national income measurement?
9. Give three determinants of national income statistics?
10. What are the uses of national income statistics?
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McConell, C. R. and Brue, S. L. (2005). Economics: Principles, problem, and policies. Sixteen
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