Open Economy Macroeconomics

National Income Identity for Open Economy

Now we all know about the imports and exports of goods, right? Increasing foreign exchange of goods and services is extremely beneficial to the country’s wealth. Here, let us learn about National Income Identity for an Open Economy and how GDP is a great international indicator of a country’s economy.

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National Income Identity

inindia-gross-national-product

(Source: Tradingeconomics.com)

A healthy economy thrives on good trade relations. Today, a lot of countries have an open economy where there are no trade restrictions. An open economy refers to an economy where people and businesses can freely trade in goods and services with other countries. There are several benefits of an open economy. With increased trade, people have a wide variety of goods and services to choose from.

They can choose to invest their money abroad. International trading is not restricted to just goods and services alone. An open economy presents innumerable opportunities for global investments and technological advancements as well. With increased trade and economic growth, what improves is the Gross Domestic Product (GDP) of the economy.

Let’s now understand how GDP works. In an open economy, the GDP is the market value of all finished goods and services produced in a country within a specific period of time. There are several approaches to calculating the GDP. The most common approach is the expenditure approach that divides the GDP into household consumption (C), investment (I), government purchases (G), and net exports (NX). Hence, you can express GDP as follows:

GDP or Y = C + I + G + NX

This expression of GDP is called the national income identity for an open economy. Let’s look at each component of the expression in detail.

Consumption

Consumption refers to the household consumption of goods and services produced domestically. It includes expenditure on durable goods (home appliances, jewellery, books), non-durable goods (food, fuel, medicines), and services (medical care or education).

Investment

The investment component in the national income identity refers to capital expenditure or investment on new capital for producing consumer goods. It does not include the exchange of existing assets and purchase of shares and bonds. Investment involves capital that can be used in the future.

The purchase of a new house by a family can be considered as an investment (for calculating GDP). However, you cannot consider investment in financial products with the intent of savings as an investment (in terms of calculating GDP). Another example would be that of a factory or company that invests in new equipment or software.

Government Purchases

The government purchases component refers to the total expenditure by the federal, state, or local governments on final goods and services. For instance, public sector salaries and purchase of military equipment and medicines would be categorized as government purchases. Government purchases do not include transfer payments (subsidies, social insurance, medical insurance), pensions, or unemployment benefits as there is nothing earned in return.

Net Exports

Net Exports refers to the difference between the total imports and exports, that is the difference between the value of goods and services exported to other countries and value of goods and services imported from other countries.

Now that you are familiar with GDP and national income identity, let’s try and understand why imports are deducted from the identity. Remember net exports (NX)? Imports have to be deducted from the identity because imports, in most forms, are usually included in the consumption, investment, and government purchases components. Hence, the imports must be subtracted to correctly calculate the value of domestic goods and services.

Let’s look at an example. When you purchase an electric appliance that is imported from another country, it is still categorized as a household consumption. Similarly, if a company imports a piece of equipment and then uses it to produce and export a finished product, then that value is included in the domestic exports. Thus, if imports are not deducted, the GDP would be incorrect.

 Let us learn in detail about the Exchange rate.

Solved Question for You

Q: Which formula correctly represents the national income identity for an open economy? or Y =

  1. C + I + NX
  2. I + NX + G
  3. C + I + G + Ex
  4. C + I + G + NX

Ans: The correct answer is option ‘d’. The national income of an open economy includes consumption, investments, government purchase and net exports.

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