To understand the economy, circular flow of income is very useful .it shows how national income can increase or decrease due to changes in the various flows of income.
In this essay I will be looking how national income can be measured using GDP.
The method GDP use in measuring the national income.
And the difficulties in interpreting GDP figure and its limitation in relation with population well being and happiness, at the end will relate it with quarterly GDP figures for the UK last year.
According to sloman & wride economics 7th Ed page 393 GDP can be defining as the measurement of total output of finish goods and services produces in a country in one year. This means measuring the total income and expenditure of a country in a specific period of time. That means it concentrate on business enterprise summing up all which the have produce.
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In measuring U K GDP the following has to be included
A service provide by government.
The benefits derived by owner-occupiers from living in a property.
The profits from the output produced in the u k by foreign owned firms.
Addition to stock made through the year
It can be measured in three ways, which all are expected to give the same answer.
The income method
The product method
The expenditure method
(John sloman. Alison Wride 2009 economics 7th edition)
The product method: the product method, which is done by summing up the valued goods and services produce in a country during the period of one year. That is the produced goods and services like cars electronics, building material and all others services. We have to be careful in the valuation of this product to avoid double counting, since it consists of various firms.
The income method: the income methods sums up the income form the produce goods and services within the economy. It is all the sum of all value added goods and services produce in the economy. That is the income earn by those involve in the production process .the figures provide break the income
C= compensation of employees (wages and salaries),
O= operating surplus (gross profit, rent and interest of firms and government and other institutions)
T =tax less subsidies on production plus statistical discrepancy.
So GDP= compensation of employees +operating surplus + mixed incomes.
The expenditure method :It measures the amount spend on all final goods produce in a year. It can be calculate by adding four-component spending. That is consumption investment, government purchase of goods and service, net export.
In equation =C+I+G+(EX-IM).
Consumption these include expenditures by households on goods and services produced in the domestic economy
Government expenditure: this includes government spending on capital goods and services. It also includes non-marked services like health and education but transfer of payments, Such as benefits, pension, and scholarship are not included.
Investment expenditure: it is the total investment on capital equipment and buildings by firms and expenditure on new residential houses by households. It also include change in business inventories that is the amount in which firms inventories change during a period.
Exports of goods and services (X)"the reason why this is include in the calculation of GDP is because consumption, investment and government spending include expenditure on goods produce domestically and by foreigners. It overstate domestically production because it contains expenditure on foreign produce goods (imports), which will be subtracted from GDP to get the correct figure".
GDP (at market price)=C+G+I+X-M
The table below shows the calculation of 2007 UK GDP by the expenditure approach.
For us to get accurate account of GDP we have to take account of the following, Inflation.
"Taking account of inflation: for one to make a clear comparison of one year national income with another inflation must be consider .for example if this year national income is 10 percent higher than last year, but at the same time price are 10 percent higher, then the average person will be no better off at all. There has been no real increase income. This brings us into the real and nominal GDP measured at current price without considering of inflation.
Always on Time
Marked to Standard
Real GDP take account of inflation that means GDP measured in constant prices".
"Population: the use of per-capita measures
We looking at the total GDP figures though the important in showing how big a country is in comparing with other, we are often more interested in output or income per head. Countries like Luxembourg obviously has a much lower total national income than UK but higher GDP per head. China is often referred to be the third largest economy in the world and as likely to overtake USA by 2040. But these are total figures. GDP in china is only 11 percent of that of USA.
There are other per-capita measures that are useful .for example measuring GDP per head of employed population allows us to compare how much the average worker produce."
Exchange rate: the use of ppp measures
We encounter problems when we compare GDP figures of different countries. They are being measured in local currency and have to be converted into a common currency (e.g. dollars or euros) at the current exchange rate. But the exchange may be poor indicator of purchasing power of the currency at home.
For example £1 may exchange for, $180. But will £1 in UK buy the same amount of goods as $180 in USA? The answer is no.
To compensate for this GDP can be converted into a common currency at a purchasing power -power party rate. This is a rate of exchange that would allow a given amount of money in one country to buy the same amount of goods in another country after exchange it into the currency of other country.
Taking account of all these will give a good indication of level of production, that is if we no their difference between the measures.
Every one believes that increase in production is good but some problems arise when we use GDP as a measure of happiness or welfare.
Limitations of GDP in measuring happiness or welfare
Some of the limitations are
Measuring of non marketed item (unpaid economics activity): a paid nanny's income contributes to GDP statistics. But unpaid parent time spent doing the same job will not be counted since is unpaid.
Though both parties are carrying out the economic activity .the exclusion of unpaid economic activity means that GDP statistics understates the true level of production in the economy. If there is an increase in the amount of unpaid economic activity that people perform, the figures will understate the rate of growth of national output.
Underground economy: according to Karl E. case it is the part of in which transactions take place and in which income is generated that is unreported and therefore not counted in GDP. That is it consist of illegal transaction that go unnoticed unless they are channel into a legitimate business. In calculating GDP some income generated but not declare for tax purpose are missed. For example unemployed person may do some jobs that he did not declare, to avoid losing his benefit. Another example is black market.
GDP ignores externalities
The building of many industrial society increase GDP Statistic, but the environmental effect like pollution of water and air, the global warming is not recorded in GDP. If these external cost is recorded in GDP the net benefits of the industry might be small.
GDP takes no account of input use to produce output: for example if production increases as a result of people work harder or working twice the hours, then it increases GDP and this dose not mean that workers are happy as they will have less leisure time.