The Concept of Income in a General Equilibrium

Abstract

This paper derives a concept of aggregate income for a competitive economy in general equilibrium consisting of heterogeneous infinitely lived people and relates it to current and future consumption possibilities. An important characteristic of our measure of income, which we call Real Income, is that deflation is carried out using a consumption deflator rather than any price index of output. We suggest that it may be inappropriate to regard capital gains income. We also present a coherent treatment of effects of changes to terms of trade on Real Income and explain implications of this for resourceexporting economies. Hicks (1939) defined income the maximum amount a man can spend and still be well off at end of week at Since then, there has been a succession of attempts to apply this definition. The problem is, Hicks acknowledged, that correct interpretation of as well off' is by no means clear. Weitzman (1976) and Asheim (1997) suggest that income is equal to level of consumption which could be sustained indefinitely out of capitalized value of current income and equate this to being well off at end of week at beginning. Eisner (1988) argues specifically that in a total incomes system, effects arising from asset price changes and conventionally regarded capital gains should be included with income. Here, building on earlier work by Sefton and Weale (1996), Asheim and Weitzman (2001), and Pemberton and Ulph (2001), we provide a comprehensive account of implications of idea that as well off' should be understood to mean that present discounted value of current and future utility should be unchanged over interval considered. We work in context of a general equilibrium, taking prices established in general equilibrium given. We first look at income from production side, showing that in an economy where prices and interest rates satisfy an intertemporal efficiency condition, income along an equilibrium path can be interpreted a weighted average of value of current and future consumption bundle plus a term adjusting for changes in nominal price level. Converting prices to real prices by deflating by Divisia consumption price index removes need for this adjustment. These results are suggestive. First, they offer a way of defining income of a household entirely in terms of its consumption possibilities. Second, they indicate that, to calculate income, deflation is best carried out using a price index of consumption; this is a substantial divergence from current national accounting practice. Third, because we have assumed constant returns, there is a trivial aggregation result that aggregate income is equal to sum of incomes from individual sectors.