SESSION 5: FACTORS INFLUENCING THE SIZE OF NATIONAL INCOME
We have been able to describe the national income and its macroeconomic applications. Just as the income of any laborer or company can be affected by a number of variables, so too can the national income.
Read ahead: SESSION 6: CIRCULAR FLOW OF INCOME
This session will examine the multitude of factors that affect the magnitude of national income.
Objectives By the end of this session, readers should be able to
- (a) outline the factors influencing the size of national income
- (b) differentiate between real GDP and nominal GDP
- (c) enumerate the other indicators of economic activity
Now read on…
- Session 1: Macroeconomics and Business
- Session 2: Macroeconomic Policies and Economic Policies
- Session 3: Government and the Economy
- Session 4: National Income Accounting
- Session 6: Circular Flow of Income
5.1 Factors Influencing the Size of National Income
The overall size and rate of growth of national income and output and thus economic activity depend on several factors. A number of these factors have been explained below:
- Availability of natural resources A country with more natural resources has more potential wealth to exploit, whereas a country with few natural resources (e.g. a desert country with no oil) may be very poor.
- Natural resources might be only partly exploited, but in some countries, environmental considerations might result in conscious decisions by the government not to exploit certain resources.
- Nature of the labor force The size, energy, and skills of the workforce affect potential national income because a more productive workforce will be capable of producing a greater gross domestic product. Technical training and education are important ingredients contributing to labor skills.
- Amount of capital investment Greater amounts of expenditure on investment will contribute immediately to gross domestic product but the investment capital will then be used to produce more output for consumption in future years. Some countries attract capital investment more easily than others and an efficient financial services sector will ensure that funds supplied by savers are channeled into worthwhile investments.
- Efficient utilization of resources The efficient combination of land, labor, and capital contributes towards greater productivity and thus higher gross domestic product. Poor countries of the world are unable to achieve such an efficient combination, most noticeably because of inadequate capital investment and a lack of entrepreneurial skills.
- Innovation Innovation is key to the growth of output and expansion of the industry. Successful innovation usually occurs in countries with a good educational system as well as significant investment in research and development.
Political stability Politically unstable nations will likely struggle to attract new investment, both domestically and internationally.
The workforce and the day-to-day operations of corporations may be directly impacted by social unrest, which may take the form of widespread strike action.
Direct foreign investment will help increase the gross domestic product and national income, despite the fact that foreign investors will expect a financial return.
5.2 Real versus Nominal Values
To determine changes in the magnitude (or volume) of economic activity, it is necessary to eliminate the effects of inflation. Therefore, activity indicators are expressed in actual or volume terms.
Therefore, real gross domestic product (GDP) statistics are expressed at constant prices (i.e., relative to prices in a base period).
In periods of rapidly rising prices, failure to remove the effects of inflation would result in grossly inflated estimates of economic activity; nominal values would therefore be unsuitable as indicators of growth in output volume.
To deflate nominal GDP (measured at current prices), an appropriate inflation estimate must be utilized. The GDP deflator is the most all-encompassing metric.
5.3 GDP Deflator
The GDP deflator is the weighted average of prices of all goods and services produced in an economy and purchased by households, firms, governments, and foreigners.
Illustration If the nominal GDP in a particular year (say 2018) is GHS4 billion, and the GDP deflator for that year is 115 (ie. 15% above the general level of the base year, say 2000, set at 100).
Required: Compute the real GDP in 2018 expressed in the base year (2000 prices).
Hint: Real GDP2018 =Nominal GDP 2018 * Base year price level
Real GDP2018 = 4Billion x 100 = GHC3.478bn
5.4 Other Indicators of Economic Activity
Indicators of economic activity are not limited to the direct output and income components discussed previously. As long as they shed light on the condition of demand and the general level of economic activity, they can take almost any form. The following additional indicators are discussed briefly:
5.4.1 Monetary aggregates
We can infer the level of economic activity based on the messages conveyed by the growth of the money supply regarding the demand pressure.
The monetary aggregates reflect both the inflation rate and the level of economic activity (price and volume fluctuations).
The quantity of credit extended to consumers can be viewed as a proxy for consumer spending.
5.4.2 Business survey data
This provides a more current portrait of activity than the official national output economic statistics. These surveys employ a qualitative approach, asking respondents to compare the business climate between two distinct time periods.
The emphasis may be on general optimism regarding the economic prognosis of an economy. Essentially, this information predicts whether activity will increase or decrease relative to a previous period.
5.4.3 Labour market statistics
In general, labor market statistics are another indicator of the economic climate. Information from the labor market includes unemployment rates, job openings, and estimates of the number of employed individuals in the economy.
Such information is crucial during economic recoveries, signifying perhaps a potential labor shortage.
5.4.4 Cyclical indicators
In addition to those already mentioned, there are a plethora of economic indicators for individual sectors, ranging from new construction orders and housing statistics to the weekly sales figures of a single department store. In addition, we always have our own ‘natural instinct’.
At turning points, such as the peak or trough of the business cycle, there will typically be no consistent picture arising from these numerous sources. To interpret and explain such diverse indicators necessitates a substantial amount of discretion.
The magnitude of a country’s national income is influenced by a number of factors, as demonstrated in this session.
We were also able to distinguish between real and nominal GDP and reached the conclusion that the information from national income accounts should be used in conjunction with other indicators of economic performance and living standards to provide a more complete picture of an economy’s health.
- What factors influence the size of national economies?
- Describe in detail the difference between real and nominal GDP.
- Apart from official GDP statistics, what other information might suggest that an economy is heading toward a recession (defined as more than two consecutive quarters of falling output)?
- What is the GDP deflator? Why is it a comprehensive measure of inflation? 5. How does innovation influence the size of the GDP?