Real National Income

By Sefton, James; Weale, Martin | National Institute Economic Review, February 1996 | Go to article overview

Real National Income


Sefton, James, Weale, Martin, National Institute Economic Review


What do we mean by a country's real income? There are in fact two different approaches here. One, which we address here, is the question of interpreting the existing definition of income. The other is the widespread view that income ought to measure 'sustainable consumption'. The origin of the idea that income should be a measure of sustainable consumption can be traced back to Hicks (1939). He suggests that income should be:

'the maximum amount of money which the individual can spend this week and still expect to be able to spend the same amount in real terms in each ensuing week' (p. 174, op cit).

Despite the current popularity of this idea it is plain that the author was not happy with the concept. For we find later that 'income is a concept which is best avoided' (Hicks, 1939 p. 177).

However, an existing measure of income does not become invalid or wrong simply because. it is not equal to sustainable consumption. In this article we argue that a conventional definition of income is not equal to sustainable consumption but that it can be related to current and future consumption. We discuss a number of practical issues concerning the implementation of this measure before providing estimates of this measure of real income for the United Kingdom in the 20th century. However, we do not discuss any link between income and welfare, and this rather technical issue is covered by Sefton and Weale (1996).

Income in a competitive economy

What then is income equal to? How does it relate to current and future consumption? We can answer this question by observing that growth in income arises first from increases in the capital stock made possible by net saving, and secondly from non-economic factors such as growth in the labour force and exogenous technical progress. In a competitive economy an increase in the real net capital stock of [Delta]K will lead to a permanent increase in income equal to the growth in the capital stock multiplied by the real rate of interest. The real rate of interest is defined as an own-rate of return in consumption goods, and this proposition therefore holds if both income and the increase in capital are measured in terms of consumption goods(1). Both income and the increase in the capital stock have to be measured net of depreciation. In addition, there may be an increase in income arising from technical change and growth in the labour force, which can be described as effects of time. This also has to be taken into account.

The relationship can be expressed formally as

[Delta][Y.sub.t+1] = [r.sub.t][Delta][K.sub.t] + effects of time (1)

The increase in the net capital stock is equal to the amount saved out of income in period t, or to the amount of income which is not consumed. This means that we can write

[Delta][Y.sub.t+1] = [r.sub.t]([Y.sub.t] - [C.sub.t]) + effects of time (2)

This expression allows us to substitute out future levels of income, to produce an expression linking current income to future consumption

[Mathematical Expression Omitted]

If the effects of time are such as to lead to an increase in income independent of saving, then this function indicates the obvious point that future consumption levels can be higher than current income alone would justify.

The expression can be rearranged, to indicate the link between income, current consumption and future changes in consumption

[Mathematical Expression Omitted]

Income Defined

Equation (4) provides a clear definition of real income as it is conventionally measured but defined in terms of consumption goods. In the absence of effects arising purely from the passage of time, real income net of depreciation is equal to the sum of current consumption and the value of all future increases in real consumption discounted at the appropriate real rates of interest. In the presence of income growth arising from the passage of time, the current level of net real income is equal to current consumption plus the discounted value of those increases in consumption which arise only from the effects of net saving. …

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