Economics: Theory of National Income

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A country’s national income is used to measure the goods and services produced within a period of one year. The theory of national income illustrates how wealth flows within an economy. In addition, the theory of national income can be used to determine the size of a country’s economic activities. National income can be determined by measuring a country’s national output, national income and national expenditure. National income circulates within the economy (Kennedy 76). For example, in their operations, firms produce goods and services which are referred to as output. The factors of production used, that is land, labor, capital and enterprise, earn income in the form of wage, rent, wages, salaries, interest, profit and dividends, respectively. The income is further spent on other goods and services thus creating more income. This means that the earnings (income) is spent (expenditure) on other products and services (output). Therefore, Output= Income-Expenditure.

Circular flow of income is defined as the flow of income, goods or services across different economic sectors. It is used to illustrate the existing relationships within an economy (Ohri 15). A country’s circular flow of income can be evaluated on the basis of either closed or open economy. A closed economy entails an economy which there is neither government intervention nor interaction with the world economy through international trade. Households aid firms to undertake their production process through provision of labor as one of the factors of production. In return, households are compensated in form of wages and salaries which form the households’. In order to satisfy their needs, households purchase goods and services from the firms. However, they do not consume all their income. A certain proportion is saved in such as through the banks. Purchases by households enable firms to make a profit which is invested in other economic avenues. The circular flow of income in a closed economy is illustrated below.

Employment Levels

The circular flow of income affects employment levels, output levels and the standard of living in a nation. The employment level in a nation is affected by several demand- related factors. The components of aggregate monetary demand that affects employment levels in a given country include consumption, investment, government interventions as well as exports and imports. A reduction in consumption and investment levels, government intervention as well as an increase in imports reduces the level of employment in the country as well as the National Income. On the other hand, an increase in consumption and investment levels, government spending as well as exports, increases the level of employment in the country and the National Income.

Output Levels

The circular flow of income affects different sectors of the economy which have a direct influence on the money spent on production means and processes of the economy as well as employment levels. When more money is withdrawn from the circular flow, it affects the inputs for production; less is earned from the exports implying that the country achieves low output. However, when more money is injected into the economy through investments, more goods for domestic consumption and exports is produced, the level of employment also increase and more revenue is collected and therefore the country records higher output.

The Standard of Living

The standard of living in a nation is the total goods and services that are consumed by all the households within the given nation in the particular year as a proportion of the Real National Income contributed by the country’s population. A high standard of living indicates high consumption of goods. The levels of consumption are affected by the level of employment and the amount of income of the nation which again are affected by factors that influence the circular flow of income.

Injections and withdrawals from the circular flow

Injections and withdrawals occur in an open economy which includes the government and the world economy. These two components affect the circular flow of income and hence a country’s economic activity. According to Agarwal (13), the circular flow of income can be constant if household expenditure on products and services is distributed as factor payment. However, existence of injections and withdrawals limits this. Withdrawals involve all the income generated through the production of national output but does not enter into the circular flow. On the other hand, injections include money spent by different economic sectors and are an increment to their income. Injections enter the circular flow of income. The chart below illustrates injections and withdrawals in the national income.

Injections and withdrawals in the national income

Savings by households

Savings refer to the proportion of income not spent by individuals. An individual’s desire or thrift to save a proportion of his or her income is referred to as the Marginal Propensity to Save (MPS). The household’s MPS is determined by the level of income. Savings involve the difference between an individual’s income and his or her consumption, that is S=Y-C where S=savings, Y=disposable income and C=Consumption. Therefore, if an individual’s income is high, then there is a high probability of his MPS being high and vice versa. Despite saving being good, it can affect the national economy negatively. This arises from the fact that savings are a leakage or a withdrawal from the circular flow. As a result, money is withdrawn from the circular flow. This is due to the fact that the money saved is not spent on purchasing goods and services. This means that savings represent a reduction in an individual’s consumption. If the marginal propensity to save amongst the households in a given country is high, the amount of money in the circular flow can be reduced culminating into reduction in economic activity.

For example, when the amount of money saved by households becomes greater than the amount of investment injected into the economy, the country is bound to experience a reduction in capital flow to inject into manufacturing activities. This would in turn lead to low output and a reduction in employment levels and this will certainly lead to inflation as the demand for goods will have to increase. This implies that the high savings will have limited the country’s capacity to produce goods and services which can sustain its demands and surplus for exports and as a result the savings will have no real effect on the households.


Upon importing products and services, a significant proportion of money flows out of the economy. The money spent of purchasing goods from abroad is injected into the circular flow of income of the foreign country. This means that money spent on imports enhances the economic activity of the foreign economy. This means that imports lead into a decline in the country’s circular flow of income while that of the foreign country is improved. The resultant effect is a decline in the country’s economic activity.

For example, the highest sector value in the UK’s economy is manufacturing. This means that an increase in spending on manufactured goods such machineries and equipment would lead to money being withdrawn from the country’s economy as it purchases the goods to satisfy its national demands. The money available for production is therefore reduced leading to low output and income. The amount of revenue collected is reduced as employment levels are also reduced.

Tax paid to the government

The government has a significant effect on a country’s circular flow. One of the ways through which it attains this is by taxation. The government levies various taxes on individuals and firms. For example, households pay direct tax such as income tax and indirect tax upon purchase of products and services. On the other hand, firms pay direct tax such as corporate income tax and indirect tax such as excise duties and sales tax. Through taxation, a significant amount of money is taken out of the country’s circular flow.


Government spending

The government also affects the circular flow of income through its spending. There are a number of ways through which the government spends its revenues. For example, through its spending in form of transfer payments, pensions and unemployment benefits, the government injects money into the economy. Other forms of government spending include expenditure on administration and defense. Governments spending also take the form of subsidies which are given to firms in order to stimulate their production. As a result, a significant amount of money is injected into the economy. Such forms of government expenditure stimulate a country’s economy leading into economic expansion.


Exports refer to goods and services which are sold in the international market. The receipts obtained from exports increase a country’s level of national income. The money received is consumed in the local economy in various economic sectors. The resultant effect is an increment in the amount of money in the circular flow. This means that the country’s economic activity is stimulated.

Investment by firms

Households and firms conduct investment in different economic sectors; however, firms are the major investors although it is not guaranteed whether firms would invest all the money withdrawn form economy’s circular flow of income. This arises from the fact that they may not invest considering the existing rate of interest and also future expectations. A certain proportion may be spent on other areas thus reducing the circular flow of income. The money used to undertake investment may be savings or loans from financial institutions.

Through investment, additional amount of money is introduced into the circular flow. As a result, the production capacity of an economy is improved. In addition, investment by firms leads to creation of demand for the resulting products and services.

In achieving equilibrium, investment must be equal to the level of income as well as savings. This implies that when investments are higher than savings, then it is expected that the aggregate demands will be greater than the current output. This means that firms will increase their production which will in turn lead to a rise in the level of employment. This increases the National Income of the country. Conversely, when savings are higher than investment, then the aggregate demand will certainly decrease below the rates of the current output. This implies that firms will have to decrease their production and this in turn would result to low levels of employment which also affects the National Income negatively.

Difficulties encountered in measuring the National Income of a country


In determining GNP, the items which are paid for are considered. This arises from the fact that money GNP is determined in monetary form. This means that goods and services whose value cannot be accounted for in monetary terms cannot be accounted for. For example, imputing a value on some activities which are meant to benefit self such as painting one’s own house, cleaning a car or painting one’s house would be difficult while excluding other such as cooking, cleaning, shaving may distort determination of the GNP. An imputed monetary value is only considered as a component of a person’s income if it forms a part of his or her income such as goods produced and consumed by a farmer.

Inadequate information

In the determination of national income, there is no specific source of information. Some of the information obtained may be insufficient due to exclusion of some components such income from government owned companies. Another factor which may lead to inadequacy of information includes exclusion of some income groups such as the small income groups. Information regarding a country’s production are taken after a duration of five years. As a result, intense estimation is done on the figures. In addition, inadequacy of information also arises from ineffective determination of depreciation figure with regard to the fixed assets. The figure used is the book value which is usually determined through tax regulations. This means that the figures obtained to not represent real depreciation.

Value of service rendered by consumer durable goods

Some goods and services offer service to consumers for a long duration of time. Example of these products includes television, table, cars and dishwashers. In addition, it is difficult to impute value on these products and services on an yearly basis. This means that the value of these goods and services are included as their full value when they were bought. As a resulted, subsequent services rendered by these products are ignored. However, owner-occupied houses are given an imputed value through the rate-able value. In addition, the value of owner-occupied houses is included in the notional rent. This prevents a country’s Gross National Product from declining.

Multiplier effect and the national income

The multiplier effect can be used to influence a country’s aggregate demand and hence the national income. Multiplier effect arises from injections or withdrawals within an economy’s circular flow of income. This has a relatively greater effect on the National Income. The resultant effect is that more spending is stimulated. Injected money into the economy leads to increase in the flow of income which in turn increases the National Income. The value of the MPC and MRC determines the amount spent or saved out of the National Income. The amount spent and saved decreases each time the money leaks back into the economy. Injections have multiplier effects particularly in an economy where the value of MPC exceeds the value of MRC. In such a case, investments lead to increase in national income. However, if the value of MPC is 1, then the country can not experience any multiplier effect despite investments since investments are used to generate more income. Injection increases spending, which in turn increases income and output as well as employment.

For example, a firm may decide to increase its capital investment with a margin of 300 pounds by purchasing new machineries. The local firms which deal with production of capital goods will increase their production due to increased demand. The resultant effect is an improvement in the firm’s level of profit. If the firm makes a decision to spend approximately 60% of the profit, there will be an addition of 180 pounds to other individual’s income. As a result, total income has increased with 180 pounds, [300+ {60%*300}] = 480 pounds.

The producers of the additional goods may decide to spent 60% on others, the national income will be [300+ {60%*300} + {60%*180}] = 588 pounds. This process continuous indefinitely.Therefore, multiplier effect can be used to enhance national income by increasing propensity to consume local products and services.

An example of multiplier effect would occur when a new foreign firm invests into the country, employ people and purchase equipment from within or import the equipment. The money that it spends in its business processes including paying employees, spread in the country’s economy creating multiplier effect. The revenues paid to the government while importing equipment or while carrying out its other business processes are injected back into the economy.


Agarwal, Vanta. Macroeconomics. Sydney: Pearson Education India, 2007. Print.

Kennedy, Peter. Macroeconomics essential. Massachusetts: MIT Press, 2000. Print.

Ohri, Jain. Introductory microeconomics and macroeconomics. New York: FK Publication, 2008. Print.

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EduRaven. (2022, March 30). Economics: Theory of National Income. Retrieved from


EduRaven. (2022, March 30). Economics: Theory of National Income.

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"Economics: Theory of National Income." EduRaven, 30 Mar. 2022,


EduRaven. (2022) 'Economics: Theory of National Income'. 30 March.


EduRaven. 2022. "Economics: Theory of National Income." March 30, 2022.

1. EduRaven. "Economics: Theory of National Income." March 30, 2022.


EduRaven. "Economics: Theory of National Income." March 30, 2022.


EduRaven. 2022. "Economics: Theory of National Income." March 30, 2022.

1. EduRaven. "Economics: Theory of National Income." March 30, 2022.


EduRaven. "Economics: Theory of National Income." March 30, 2022.