NATIONAL INCOME &

CIRCULAR FLOW OF
INCOME
 Assessing the Economy’s
Performance
National Income Accounting:
•Health of the Economy
•Comparisons Over Time
•Formulation of Public Policy
What Are These
Accounting
Measures?
Circular flow of Income
circular flow of income in the two sector model without
savings

  To analyze the two sector model, assume that there are no
savings in the two sector economy, consisting of only
households and firms. Households cannot produce all goods
and services. They have to buy some commodities or goods
from other producing units i.e. business firms. Therefore,
there is a flow of consumer goods from firms to households.
This flow of goods leads to the flow of income to the business
firms. According to the national accounting system, national
income is equal to national expenditure (which we shall
discuss in detail later). So, in the two sector model of
economy, total earnings of households is equal to total
expenditure of households.
 In the above analysis of the circular flow of money
and incomes, it was assumed that households spent
their total earnings on consumer goods and
services. This is impossible in real life. The part of
income that is not spent is called savings. This can
be mathematically expressed as
S = Y- C, where Y is income, C is consumption,
and S is saving.
Circular Flow of Income in a Three Sector Economy

 In a modern economy, the government plays an

important role in facilitating business activity. It
also has an impact on the circular flow of income.
The government has many sources of revenue, but
the main source is taxes. Taxes are levied both on
households and business firms.
Circular Flow of Income in a Four Sector Economy

 In today's globalized business scenario, all

countries have trade relations with other countries.
If a country import goods from another country, the
amount spent on imported goods by households is
received by factors of production in the exporting
country.
 FACTORS AFFECTING THE SIZE OF A
NATION'S INCOME
 The quantity and quality of the factor endowment of a nation play an important role in
determining the size of the national income. If a nation possesses large amounts of
natural resources and skilled manpower, it is termed rich. Broadly speaking, natural
resources, human resources, capital resources and self sufficiency are the factors that
affect the size of the national income.
 (a) Natural resources: These include minerals mined from the earth, agricultural
potential, and energy resources (including oil, gas, hydroelectric, thermal, and wind
power).
 (b) Human resources: If a nation has a large literate population, which is capable and
knowledgeable in wealth creating processes, the nation will have a large national income.
 (c) Capital resources: To have a good national income, a nation must create and
conserve capital resources. This includes not only tools, plants and machinery, factories,
mines, domestic dwellings, schools and colleges, but also infrastructure facilities like
roads, railways, airports, seaports and communication facilities.
 (d) Self-sufficiency: A nation cannot have large national income if its citizens are not
self-supporting and self-sufficient. Government should encourage entrepreneurial
activities that increase self-sufficiency.
Concepts of National Income
 GDP: GDP is the sum of money value of all final goods and
services produced within the domestic territories of a country
during an accounting year.

GDP = C + I + G + (X – M)
 GDP at Factor Cost and
 GDP at Market Price
 GNP : GNP is the sum of money value of all final goods and
services produced in the economy during an accounting year.
GNP = GDP + NFIA
NFIA is the difference between income received from abroad for
rendering factor services and income paid towards services
rendered by foreign nationals in the domestic territory of a country.
 YY =
= CC +
+ II +
+GG+
+ NX
NX
Totaldemand
Total demand Investment
Investment
fordomestic
for domestic isiscomposed
composed spendingby
spending by
output(GDP)
output (GDP) of
of businessesand
businesses and
households
households Netexports
Net exports
ornet
or netforeign
foreign
Consumption Government demand
demand
Consumption Government
spendingby
spending by purchasesof
purchases ofgoods
goods
households
households andservices
and services

This is the called the national income accounts identity.

11
Concepts of National Income
 NDP and NNP:
 NDP = GDP – Depreciation
 NNP = GNP – Depreciation
 NNP at Factor cost ( National Income)
 NNP at Market Price
 NDP at Factor Cost
 NDP at Market Price
 THE IMPLICIT PRICE DEFLATOR FOR GDP

GDP Deflator = Nominal GDP

Real GDP

Nominal GDP measures the current dollar value of the output of

the economy.

Real GDP measures output valued at constant prices.

The GDP deflator, also called the implicit price deflator for GDP,
measures the price of output relative to its price in the base year. It
reflects what’s happening to the overall level of prices in the economy.

13
Concepts of National Income
 PCI: is the income per person. It can be obtained
dividing the national income by the total
population.
 PCI = National Income / Total Population
 Concepts of National Income
 Personal Income: is the total income received by the
individuals of a country from all sources before direct
taxes in one year.
 Personal Income = NI (NNP at factor cost) –
undistributed profit – corporate tax + transfer payments.
 Disposable Income: is the actual income which is
available to be spent on consumption by individual or
families.
 Disposable Income = Personal Income – Personal Taxes
THE MEASUREMENT OF NATIONAL
INCOME

 There are three methods of calculating national

income, and they are all conceptually equivalent to
each other. These are:
 the output method,
 the income method and
 the expenditure method.
 Output Method
 The output method is followed either by valuing all the final goods and services produced during a
year or by aggregating the values imparted to the intermediate products at each stage of
production by the industries and productive enterprises in the economy. The sum of these values
added gives the gross domestic product at factor cost which after a similar adjustment to include
net factor income from abroad gives gross national product at factor cost.
 This approach is used to estimate gross and net value added in the primary sectors - Ex.
Agriculture, and allied activities, forestry and logging, fishing, registered manufacturing, etc. - of
the Indian Economy.
                        The Output (Value Added) Method
    The agricultural and extractive industries 10
 Plus Manufacturing industries 40
 Plus Services and construction 40
 Equals Gross Domestic Product at factor cost 90
 Plus Net factor income from abroad
(= Income received from abroad – Income paid abroad) 10
 Equals Gross National Product at factor cost 100
 Less Capital consumption or depreciation 20
 Equals Net National Product at factor cost or National Income 80
  
Limitations of Output Method
 Problem of double counting
 Not applicable to Tertiary sector
 Exclusion of Non Market Products
 The Expenditure Method
 The expenditure method aggregates all money spent by private citizens,
firms and the government within the year, to obtain total domestic
expenditure at market prices
 The Expenditure Method
   Consumer’s expenditure (C) 70
 plus Government current expenditures on goods and services (G) 20
 plus Gross domestic fixed capital formation (I) 20
 plus Value of physical increase in stocks and work in progress (I) 10
 equals Total domestic expenditure at market prices 120
 plus Exports and factor income from abroad (E) 20
 less Imports and factor income paid abroad (M) –30
 equals GNPMP 110
 less Indirect Taxes –20
 plus Subsidies 10
 equals Gross national product at factor cost 100
Limitations of Expenditure Method
 Neglects Barter System
 Ignores own consumption
 Affected by Inflation
 Income Method
 The income approach to measuring national income does not simply aggregate
all incomes.

The Income Method

Income from employment 50

 plus Income from self-employment 10
 plus Gross trading profits of companies 10
 plus Gross trading surplus of public corporations 10
 plus Rent 10
 equals Gross domestic product at factor cost 90
 plus Net factor income from abroad 10
 equals Gross national product at factor cost 100
Limitations of Income Method
 Exclusion of Non Monetary (farmer and family
working in own field)
 Exclusion of Non Marketed Services Income
( mother’s services)
DIFFICULTIES IN MEASURING NATIONAL
INCOME

 There are some conceptual and statistical problems in measuring national income.
Some items are excluded from national income accounting, even though they
should be classified as "current production" of goods and services. Sometimes
production leads to harmful side effects which are not fully taken into consideration
in calculation of national income.
 Non-market Production : National income fails to account for household
production because such production does not involve market transactions. As a
result, the household services of millions of people are excluded from the national
income accounts. For instance, housework done by housewives is not included, but
the same work done by a paid servant is. Their exclusion results in some oddities in
national income accounting and underestimates our national income.
 Imputed Values : The imputed value problem arises predominately in the
agricultural sector. Goods and services produced and consumed by the individuals
for themselves are not indicated in the national income. For example, in agricultural
sector, the value of the commodities consumed by the farmers is not calculated in
the national income. Sometimes, this may result in overestimation or
underestimation of the national income.
Cont:
 The Underground Economy : Many transactions go unreported because
they involve illegal activities. Most of these underground activities
produce goods and services that are valued by consumers. However,
these activities are unreported and not included in national income
accounts. They do not figure in the national income estimate.
 "Side Effects" and Economic "Bads" : National income accounts do not
consider the implications of some productive activities and the events of
nature in an economy. If they do not involve market transactions,
economic 'bads' are not deducted from national income. Air and water
pollution are sometimes acts as side effects of the process of economic
activity and reduce our future production possibilities. Defense
expenditure might increase national income, but may not have a positive
effect on the country. Since national income accounts ignore these
negative aspects of growth and development, they tend to overstate the
real national output.
Cont:
 Leisure and Human Cost : According to Simon Kuznets,
who propounded the concept of GNP, the failure to fully
include leisure and human costs is one of the major
drawbacks of national income accounting. National
income accounts exclude leisure, a commodity that is
valuable to everybody. Similarly, national income also
fails to take into account the human cost of employment
in terms of physical and mental strain (associated with
many jobs)
 Double Counting : There is always a possibility of some
outputs being counted twice. As a result, the national
income is exaggerated.
THE USES OF NATIONAL INCOME
STATISTICS

 As an Instrument of Economic Planning and

Review
 As a Means of Indicating Changes in a Country's
Standard of Living
 To Indicate Changes in Economic Growth of a
Country
 As a Means of Comparing the Economic
Performance of Different Countries