2.1Lending, borrowing and national income

We have noted several times that one of the functions of a nancial system is to

channel funds from those who wish to lend to those who wish to borrow: in other

words from surplus to decit units. We also know that surpluses (and decits) arise from

an inequality between current income and planned expenditure. Notice that they

are therefore the outcome of realeconomic activity. They result because people earn

incomes from employment which produces goods and services and then make deci-

sions about how much they wish to spend on goods and services. We might go further

and suppose that an economy in boom conditions generates more employment,

income and output, all of which might in turn be associated with larger surpluses, at

least amongst households. Conversely, where the level of economic activity is low,

so too is employment and incomes, and many families will nd it difcult to make

their income stretch to match expenditure. Let us be clear then that one connection

between the ‘real’ economy and the nancial system is that it is the real economy that

gives rise to the surpluses and decits which the nancial system has to reconcile.

In order to learn more about how a nancial system does this, it would be very

useful to be able to take a surplus or decit unit, begin with its income and spending

plans and then follow what happens to the resulting surplus/decit. Unfortunately,

it is very difcult to know exactly which are the decit and surplus units and even

more difcult to nd out how an individual unit deals with its decit/surplus. An

individual unit is a particular household, or person or rm, and nancial informa-

tion about individual persons, households and rms is understandably condential.

However, if we aggregate individual units into sectors, we nd that readily available

ofcial statistics will tell us both about the size of sectoral surpluses and decits and

about the ways in which they are reconciled. The statistics are imperfect, but it is still

worth doing.

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2.1 Lending, borrowing and national income

The most familiar sectors into which the economy can be divided are those of the

national income identity:

Y≡CIG(XM)

(2.1)

Students with some knowledge of macroeconomics will know that ‘national income’,

Y, can be measured either by adding all the incomes earned by factors of production

in the course of producing one year’s output of newly produced goods and services

or by adding all the expenditure on that output (additions to stocks caused by any

unsold output are treated as a form of expenditure). In other words, total income

and total expenditure are the same thing.

Whether we think of Yas total income or total expenditure, its components

appear on the right hand side of the identity (eqn 2.1). In expenditure terms we

can say that national income consists of consumption expenditure (by households),

C, investment expenditure (by rms), I, public sector expenditure (by government),

G, and expenditure on UK exports by customers overseas, X, less any spending on

imports, M, which may have been included in the other categories of spending, C, I

and G. In incometerms, then, Y is the sum of incomes paid to households, to rms,

to government and to exporters. C, I, Gand (X M) therefore represent the four

sectors into which the whole economy can be divided.

Consider now the rather obvious point that while national income must be equal

to the total incomes earned by the four sectors (and this must equal totalexpenditure

by the four sectors), it does not follow that income and expenditure must be equal

for each individual sector. It is possible for any one sector to spend in excess of its

income, provided that at least one other sector is prepared to spend less than its

income, in order that the equality of totalincome and expenditure is preserved. As

a general rule, we think of the household sector as spending less than income, rms

and governments as spending more, with the external sector producing whatever

difference is necessary to balance the other three.

In the remainder of this section, we are going to look at the household sector

in 2004. We shall see how its income exceeded spending, how this difference, with

some adjustment, can be used to arrive at a nancial surplus, and at what happened

to this surplus during the period. We shall also learn some important lessons about

the differences between stocksand ows. Before we begin though, a few words of

caution are required. The rst is that we shall be using data drawn from ofcial

statistics – after all, we want to see what happened in practice. Students who turn

to the ofcial statistics themselves, to check on our story (!) or to update it, will

nd that the ofcial statistics divide the economy into more than four sectors. In

particular, what we have lumped together as ‘rms’ appears as several categories

in the statistics. Firms are divided into industrial and commercial companies, and

various types of nancial rm. Similarly, ‘government’ appears as two categories –

central government and local government. More immediately relevant, data relating

to what we call ‘households’ covers ‘households and non-prot institutions serving

households’. Roughly, this is ‘households pluscharitable organisations’. None of this

is a major problem. It is just an example of what happens when one switches from

theory to the real world!

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Chapter 2

• The nancial system and the real economy Table 2.1Income and capital account of the household sector, 2004, £bn

Gross disposable income	768.3
plusEquity in pension funds	25.7
Total resources		794.0
lessConsumption		760.7
Saving		33.3
plusCapital transfers		8.1
lessCapital taxes		3.7
Change in net worth		37.7
lessReal capital spending		62.3
Net acquisition of nancial assets		24.6

Source: ONS, UK National Accounts, 2005, Tables 6.1.6 and 6.1.7

Gross domestic product (GDP) in 2004 amounted to £1164bn. Table 2.1 shows details

of households’ income and capital account. In the rst line, we see households’

‘gross disposable income’. This consists mainly of income from employment, minus

National Insurance contributions and taxes on income but plussocial security and

other benets received by families. The next line shows a very small item, ‘equity in

pension funds’. ‘Total resources’ tells us therefore that households had £794.0bn

at their disposal in 2004. (We shall call this ‘income’ and denote it Y.)

Understandably, most of this was spent on consumption, C. The difference is

saving, S. Economists are often interested in saving because it shows how much of

current output is not consumed and is therefore available for investment. Thus we

sometimes calculate a savings ratio and monitor its behaviour over time. The savings

ratio is often expressed as S/Y, but be aware that that Ymeans ‘total resources’. The

ratio in 2004 was 4.2 per cent.

Saving, then, is income minus consumption, YC. The next question is: what

happened to this saving in 2004? The rst part of the answer is that it was slightly

enlarged by the effect of the difference between capital transfers and taxes on capital.

They make little difference to our gures, adding £4.4bn to saving. The amount of

saving, plus this adjustment, shows the amount that households have available to

add to their existing stock of wealth. Thus, £37.7bn is shown as the ‘change in net

worth’. The second part of the answer is that a signicant part of saving was used

to buy real capital assets or, as we might say, to carry out real investment. For rms,

real investment means the purchase of plant, equipment, vehicles, etc. These are not

items which are bought by households. For them, the most commonly purchased

real capital assets are newly built houses (not existing houses).

Saving:The difference between income and consumption.

Capital spending in Table 2.1 is shown as £62.3bn, substantially more than the

saving available to nance it. The consequence is that households had either to

borrow the difference, or alternatively to dispose of nancial assets which they had

built up in the past. Whichever they chose to do, so far as the accounts are concerned

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