National income can be measured in two different ways: At market prices and at constant prices. These measures provide different perspectives on a country’s economic performance and can help policymakers make decisions regarding economic policy.
National Income at Market Prices
National income at market prices is a measure of a country’s total economic output, including the value of all final goods and services produced in the economy. It is calculated by adding up the total value of all goods and services produced in a given year, including those sold domestically and those sold abroad.
This measure of national income includes the impact of inflation, as it includes the prices at which goods and services are sold in the market. As prices rise over time, so too does national income at market prices, even if the actual volume of production remains the same.
To calculate national income at market prices, economists use the Gross Domestic Product (GDP) formula, which measures the total value of goods and services produced within a country’s borders during a specific period of time, usually a year. The GDP formula is:
GDP = C + I + G + (X-M)
Where:
C = Private consumption expenditure
I = Gross investment
G = Government consumption expenditure and gross investment
X = Value of exports of goods and services
M = Value of imports of goods and services
Private consumption expenditure (C) includes all expenditures made by households on goods and services, including durable goods such as cars and appliances, non-durable goods such as food and clothing, and services such as health care and education.
Gross investment (I) includes all expenditures made by firms on capital goods such as machinery, equipment, and buildings, as well as expenditures made on research and development.
Government consumption expenditure and gross investment (G) includes all expenditures made by the government on goods and services, including salaries of government employees, defense spending, and public infrastructure investments.
The value of exports of goods and services (X) includes all goods and services produced in the country that are sold to other countries.
The value of imports of goods and services (M) includes all goods and services produced outside the country that are purchased by domestic consumers, firms, and the government.
Once the total value of all goods and services produced in the economy has been calculated, economists subtract the value of intermediate goods and services, which are used in the production of other goods and services but are not sold directly to consumers. This is known as the value of intermediate consumption.
The resulting figure is the country’s gross domestic product (GDP) at market prices. This measure of national income includes the impact of inflation, as it includes the prices at which goods and services are sold in the market.
National income at market prices is an important measure of a country’s economic performance, as it provides a broad picture of the total value of goods and services produced in the economy. Policymakers and economists use this measure to assess the overall health of the economy and to make informed decisions about economic policy.
National Income at Constant Prices
National income at constant prices, also known as real national income, is a measure of a country’s total economic output that adjusts for the effects of inflation. It is calculated by holding prices constant over time, so that changes in national income reflect changes in the actual volume of production, rather than changes in prices.
To calculate national income at constant prices, economists use a measure called the GDP deflator, which adjusts for changes in the price level over time. The GDP deflator is calculated by dividing nominal GDP (GDP at market prices) by real GDP (GDP at constant prices) and multiplying by 100.
Once the GDP deflator has been calculated, economists can adjust nominal GDP to obtain real GDP. This allows them to compare economic performance over time, even if prices have changed.
National income at constant prices is a measure of a country’s economic output that adjusts for changes in the general level of prices over time. This measure is often referred to as “real” national income, as it reflects the actual physical output of goods and services produced in the economy, rather than just the nominal value of those goods and services.
To calculate national income at constant prices, economists use a process called “deflating” the nominal value of goods and services by a price index that adjusts for inflation. The price index used is typically the consumer price index (CPI) or the producer price index (PPI).
The process of calculating national income at constant prices involves several steps:
Calculate nominal GDP: The first step is to calculate nominal GDP using the market price of goods and services produced in the economy during a specific period, usually a year. This is done using the same formula as for national income at market prices:
GDP = C + I + G + (X-M)
Calculate the price index: The next step is to calculate the price index, which is a measure of the general level of prices in the economy. This is done by dividing the nominal value of goods and services produced in the current year by the nominal value of goods and services produced in a base year, and multiplying the result by 100.
Price index = (Nominal GDP current year / Nominal GDP base year) x 100
Calculate real GDP: The final step is to calculate real GDP, which is the value of goods and services produced in the economy adjusted for changes in the general level of prices over time. This is done by dividing nominal GDP by the price index:
Real GDP = Nominal GDP / Price index
The resulting figure is the country’s national income at constant prices, which reflects the actual physical output of goods and services produced in the economy, adjusted for changes in the general level of prices over time.
National income at constant prices is an important measure of a country’s economic performance, as it allows policymakers and economists to compare the physical output of goods and services produced in the economy over time, without the distortions caused by changes in the general level of prices. This measure is particularly useful for assessing the long-term growth of the economy, as it provides a more accurate picture of changes in the real output of goods and services over time.
Importance of Measuring National Income at Market Prices and Constant Prices
- Assessing economic growth: National income at market prices is a measure of the total output of goods and services produced in a country during a given period. It serves as a key indicator of a country’s economic growth and development, and is used to compare the performance of different countries or regions over time. By contrast, national income at constant prices provides a more accurate measure of the physical output of goods and services produced in the economy over time, adjusting for changes in the general level of prices. This allows policymakers to identify trends in economic growth and development that might be masked by changes in prices over time.
- Measuring inflation: National income at market prices is affected by changes in the general level of prices, and as a result, it is often difficult to discern whether changes in nominal GDP are the result of changes in output or changes in prices. By measuring national income at constant prices, economists can separate changes in output from changes in prices, allowing them to more accurately measure the level of inflation in the economy.
- Evaluating economic policies: National income at market prices and constant prices are both used to evaluate the impact of economic policies on the economy. For example, if a government implements a policy that increases government spending, the effect on national income can be measured at both market prices and constant prices. Measuring the impact of economic policies on national income at market prices can help policymakers assess the short-term impact of the policy on the economy, while measuring the impact on national income at constant prices can help policymakers evaluate the long-term impact of the policy on the physical output of goods and services produced in the economy.
- International comparisons: National income at market prices and constant prices is used to compare the economic performance of different countries or regions. Measuring national income at constant prices is particularly important when comparing the economic performance of countries with different inflation rates. Adjusting for changes in prices allows for a more accurate comparison of the actual physical output of goods and services produced in different countries or regions.