2 CIRCULAR FLOW AND NATIONAL INCOME

MEASUREMENT

PRINCIPLES OF

MACROECONOMICS

N. G R E G O R Y M A N K I W

PowerPoint® Slides
by Ron Cronovich

© 2007 Thomson South-Western, all rights reserved

In this chapter, we will be able to know-
 Topics covered:
 Introduction
 The Circular Flow of Income
 National Income Measurement
 Concepts of National Income
 Methods of Measuring National Income
 Problems in Calculation of National Income
 Nominal GDP
 Real GDP
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 Introduction

 National income, output, and expenditure are generated

by the activities of the two most vital parts of an economy,
its households and firms, as they engage in mutually
beneficial exchange.

 Households: Households are the suppliers of factors of

production (land, labour, capital and entrepreneur) to the
firms for production of goods and services.
 Firms: firms are the suppliers of goods and services to
households, firms in the country and abroad.

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 THE CIRCULAR FLOW OF INCOME
 Income (Y) in an economy flows from one part to another
whenever a transaction takes place.

 New spending (C) generates new income (Y), which

generates further new spending (C), and further new
income (Y), and so on.

 Thus the spending and income keep on circulating around

the economy. This is called circular flow of income.

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 THE CIRCULAR FLOW OF INCOME
Circular flow of income can be explained through
different models:

1. Simple Economy Model

2. Open Economy Model

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 THE CIRCULAR FLOW OF INCOME
1. Simple Economy Model

Simple Economy Model (Two Sectors Model)

There are only two sectors in the economy namely
households and firms.
There is no government, no financial markets, and no
imports or exports.
We imagine that the households spend all their incomes on
goods and services and the firms would sell all the
produced goods to consumers.

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 THE CIRCULAR FLOW OF INCOME
1. Simple Economy Model
 Circular Flow of Income in Two Sector Economy

Here we have two markets in this circular

 Market for goods and services
 Markets for factors of production.

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 THE CIRCULAR FLOW OF INCOME
1. Simple Economy Model
 Kinds of flows:
 The real flow: It is from households to firms in the form of factors of
production (labour, capital, land). Another real flow is from firms to
households which are goods and services.
 Money flows: Money flows from firms to households in terms of
Wages, Rent and Profit, and another is flow of money from households
to firms in terms of consumption, payment to the firms for goods and
services.
 The Payment made by firms to household for factors of production is
known as income. So the National income is the total income of all
households.
 In this simple model, the households spend all their incomes for buying
goods and services, it is called expenditure.

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 THE CIRCULAR FLOW OF INCOME
2. Open Economy Model
 This model is a more realistic representation of the economy. In this
model we introduce new sectors in the economy which are :
 Government sector.
 Financial Sector (Banks)
 Foreign sector.

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 THE CIRCULAR FLOW OF INCOME
2. Open Economy Model
Role of Sectors:
 1. In this model the households do not spend all their income, they
save some part of it. This is called saving. Thus, saving is the
difference of income and consumption (S= Y-C). The households keep
this saving in their banks.
2. The financial sector: This sector gives this saving as loans to the
business sector for investment. Thus saving flows again in the circular.
In this situation to be in equilibrium level, the saving should be equal to
investment (S = I).
3. The government sector imposes taxes on households and firms
but in return these taxes are transferred into government spending
.In this situation to be in equilibrium level, taxes should be equal to
government spending, T = G.

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 THE CIRCULAR FLOW OF INCOME
2. Open Economy Model
 Role of Sectors:
 4. The foreign sector deals with the flow of money from the rest of
the world to the local firms in the form of exports (x) and flow of
money from households to the rest of the world in the form of imports
(M).

S= Saving. X=Exports
Y= Income. M=Imports
C= Consumers spending on goods and service
I= Investments
G= Government spending
T=taxes
 
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 THE CIRCULAR FLOW OF INCOME
2. Open Economy Model
 Role of Sectors:
  

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 NATIONAL INCOME MEASUREMENT

Introduction of National Income

 Measurement of National Income refers to the calculation

of the total output or income of a country.
 Output is defined as quantity of goods and services
produced in a country in a given period of time.
 Measurement of National Income is important as it gives a
clear picture about country’s spending, income and output
for a specific period of time.

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 Meaning of National Income

 National Income refers to total ‘national output’

or value of a nation’s output during a specific
year.

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 NATIONAL INCOME MEASUREMENT

Importance of Measuring National Income

Measuring the level and rate of growth of national income is

important due to following reasons: -

1)To know the rate of economic growth of a country.

2)To know the changes in living standard of the people.
3)To understand the changes in distribution of income
between different groups of people

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 CONCEPTS OF NATIONAL INCOME

1) Gross Domestic Product (GDP)

2) Gross National Product(GNP)
3) Net National Product (NNP)
4) Net Domestic Product (NDP)
5) Personal Income (PI)
6) Disposable Personal Income (DPI)
7) Per Capita Income (PCI)

 
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 CONCEPTS OF NATIONAL INCOME

1) Gross Domestic Product (GDP)

Gross Domestic Product (GDP)
GDP is the total market value of all final goods and services
produced within the domestic boundaries of a country in a
year.
It is the value of goods and services produced within the
boundary of a country by nationals or foreigners.
Example: If a Japan based car producer Honda works in
Oman, the value of output will be added in GDP of Oman

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 CONCEPTS OF NATIONAL INCOME

2) Gross National Product(GNP)

Gross National Product(GNP)
GNP is the total market value of all final goods and services produced
by the residents or citizens of a country, even if they are living in other
countries.
In other words, it is the amount of goods and services produced by
residents of a country regardless of where that production takes place.
Example – Oman’s GNP values is the value of output produced by
Omani citizens’ companies regardless of where the firms are located.
GNP = GDP + Net factor income from abroad.

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 CONCEPTS OF NATIONAL INCOME

3) Net National Product (NNP)

Net National Product (NNP)
NNP is the market value of all final goods and services after
providing for depreciation.
That is, when charges for depreciation are deducted from
the GNP we get NNP at market price.
Therefore’
NNP = GNP – Depreciation
Depreciation is the consumption of fixed capital or fall in the
value of fixed capital due to wear and tear.  

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 CONCEPTS OF NATIONAL INCOME

4) Net Domestic Product (NDP)

Net Domestic Product (NDP)

Net Domestic Product can be obtained by deducting
depreciation from GDP.
Thus,
NDP= GDP – Depreciation

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 CONCEPTS OF NATIONAL INCOME
GDP (Gross Domestic Product) Versus GNP (Gross National Product)

 GDP is the total market value of goods and services

produced within the domestic borders of a country,
regardless of the nationality of those who produce them.
 GNP is the total market value of goods and services
produced by the citizens of the country, even if they are
living abroad.

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 CONCEPTS OF NATIONAL INCOME

5) Personal Income (PI)

Personal Income (PI) 
This is the actual income received by individuals and
households in the country from all sources.
It denotes aggregate money payments received by the
people in the form of wages, interest, profits and rents etc.

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 CONCEPTS OF NATIONAL INCOME

6) Disposable Personal Income (DPI)

 Disposable Personal Income

 What remains after deducting tax from personal
income, is called disposable income.
Thus,
 Disposable Income = Personal income – personal taxes,
property taxes, and insurance payments

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 CONCEPTS OF NATIONAL INCOME

7) Per Capita Income (PCI)

Per Capita Income (PCI)
Per Capita Income can be defined as average income
earned per person in a country in a specific year.
It is obtained by dividing country’s total income by its
population.
Thus,
PCI= Country’s total income (National Income)
Country’s population

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METHODS OF MEASURING NATIONAL INCOME

 Production generate incomes which are again spent on

goods and services produced.
 Therefore, national income can be measured by three
methods:
1) Output or Production method
2) Income method, and
3) Expenditure method.

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METHODS OF MEASURING NATIONAL INCOME
1) Output or Production Method:

Output or Production Method:

This method is also called the value-added method.
Under this method, the economy is divided into different
sectors such as agriculture, fishing, mining, construction,
manufacturing, trade and commerce, transport,
communication and other services.
GDP (Y) =Agricultural sector output + industrial sector
output + service sector output

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METHODS OF MEASURING NATIONAL INCOME
2) Income Method:

Income Method:
According to this method, national income is obtained by
summing up of the incomes of all individuals in the country.
Thus, national income is calculated by adding up the rent of land,
wages and salaries of employees, interest on capital, profits of
entrepreneurs and income of self-employed people.
This method of estimating national income has the great
advantage of indicating the distribution of national income among
different income groups such as landlords, capitalists, workers,
etc.
GDP (Y) = Wages + Profits + Interest + Rent

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METHODS OF MEASURING NATIONAL INCOME
3) Expenditure Method:

 Expenditure Method:
 This method arrives at national income by adding up all
the expenditure made on goods and services during a
year.
 Thus, the national income is found by adding up different
types of expenditure by households, private business
enterprises and the government.
 Computation of GDP under expenditure method
 GDP (Y) = C + I + G + (X – M)

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METHODS OF MEASURING NATIONAL INCOME
3) Expenditure Method:

Components of GDP under expenditure method

GDP (Y) = C + I + G + (X – M)
Consumption Expenditure (C) – This means expenditure for
households for food, shirt, education, automobile, refrigerators etc.
Expenditure for investment (I)–This means business
investment. Example-: Purchase of machinery for a factory, purchase of
a software, construction of new factory etc.
Government Expenditure (G) – This includes salaries for government
employees, purchase of weapons for military etc.
Exports (X) – Goods and services sent to other nations.
Imports (M) – Goods and services received from other nations.
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 Practical Exercise
In each of the following cases, determine how much GDP
and each of its components is affected.
 Mr. Hamood spends 300 OMR for the lunch of his family at a restaurant in
Muscat.
• Since Mr. Hamood spends for food here, it is consumption expenditure and
GDP of the country will increase for 300 OMR.
 Ms. Safiya spends 360 OMR for purchasing a laptop to use in her business.
• Here the expenditure is for business, so it is investment and GDP of the
country will increase for 360 OMR.
 Mr. Mustafa bought a photocopier machine for 450 OMR for his printing
business. He got last year’s model on sale for a great price from a local
manufacturer.
• Here the expenditure is for business, so it is investment. Since the
photocopier has produced in last year it will not be considered in current year
GDP calculation. So the Investment and GDP values will not be changed.

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 Practical Exercise
Calculate the GDP-
 Assume that Oman’s GDP consists of coconuts.
 Out of that, 7 tones of its GDP is imported,
 87 tones are consumed,
 10 tones go for government purchases to feed the army;
 6 tones go into domestic investment.
 In addition, there is 4 tons that is exported to other countries.
 Calculate the GDP of Oman according to this composition.
 Answer-
 GDP (Y) = C+I+G+(X-M) 
 GDP (Y) = 87+6+10+ (4 – 7) = 100 tons of coconuts.
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PROBLEMS IN CALCULATION OF NATIONAL INCOME

1) The Problem of Double Counting 

2) The Problem of Transfer Payments
3) Problems arising from the Arbitrary Definition of
Income
4) Problems of Self-Consumed Production
5) Problems of Barter Economy

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 PROBLEMS IN CALCULATION OF NATIONAL INCOME
1) The Problem of Double Counting:

The Problem of Double Counting: 

In national income calculation, only the value of final goods
and services is calculated.
Many goods go through many stages before reaching
market.
Example: wheat changed into bread. In this case only the
value of bread is calculated in the National Income.
Calculating the value of wheat and the value of bread will be
double counting.

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 PROBLEMS IN CALCULATION OF NATIONAL INCOME
2) The Problem of Transfer Payments:

The Problem of Transfer Payments:  

An example of transfer payments is pension.
The receiver of pension does not produce anything for this
money.
So this transfer payment should not be included in the
National Income calculation.

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 PROBLEMS IN CALCULATION OF NATIONAL INCOME
3) Problems arising from the Arbitrary Definition of
Income:
Problems arising from the Arbitrary Definition of
Income:
Service rendered by housewives is not included in national
income.
But if the same services are done by another servant
maid; it is calculated in national income.

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 PROBLEMS IN CALCULATION OF NATIONAL INCOME
4) Problems of Self-Consumed Production:

Problems of Self-Consumed Production:

Ahmed produces dates. He does not sell these dates in
the market.
But these dates are used for his family.
In this example, the value of the date is not calculated in
national income because these dates are used for self-
consumption.

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 PROBLEMS IN CALCULATION OF NATIONAL INCOME
5) Problems of Barter Economy:

Problems of Barter Economy:

When goods are exchanged for goods, such transactions
are not included in national income.
For example: the value of opium, bought and sold in black
market is not calculated in national income.

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 NOMINAL GDP

 Nominal GDP means it is the money value of gross

domestic product in current price.
 It is the value of all final output produced in an economy
during a given year, calculated using the present price in
which the output is produced.
 It will include all the changes in current market prices that
have happened due to inflation or deflation.
 So, nominal GDP, it is not corrected for inflation.
 Nominal GDP
= Current Year Price x Current Year Output

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 NOMINAL GDP
Practical Exercise

(Compute nominal GDP in each year)

  Mango Dates

Year Price Quantity Price Quantity

2005 $10 400 $2.00 1000

2006 11 500 2.50 1100

2007 12 600 3.00 1200

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CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 40
CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 41
 NOMINAL GDP
Here in order to calculate the Nominal GDP for each year the total value of products
have to be computed in the following way.

  Mango Dates
Year Price Quantity Price Quantity
2005 $10 400 $2.00 1000
2006 11 500 2.50 1100
2007 12 600 3.00 1200

 Nominal GDP= Current Year Price x Current Year Output

 Nominal GDP for 2005: ($ 10 x 400) + ($ 2 x 1000) = $ 6,000 

 Nominal GDP for 2006: ($ 11 x 500) + ($ 2.50 x 1100) = $ 8,250
 Nominal GDP for 2007: ($ 12 x 600) + ($ 3 x 1200) = $ 10,800 

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CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 43
CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 44
 NOMINAL GDP
Percentage changes in the nominal GDP can be calculated by using the
following formula: -

Percentage Changes in GDP = New GDP Value ― Old GDP Value X 100

Old GDP Value

Percentage Changes in Nominal GDP for 2005 - $ 6,000 = NIL

Percentage Changes in Nominal GDP for 2006
= $ ((8,250 -6000) /6000 ) X 100 = 37.5 %
Percentage Changes in Nominal GDP for 2007
= $ ((10, 800 -8250) /8250 ) X 100 = 30.9%

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 NOMINAL GDP
Here in order to calculate the nominal GDP for each year the total value of products have to
be computed in the following way.

 Normally the Nominal GDP doesn’t give a true picture about the total
GDP of country because of the changes in the current market price
of goods and services (inflation or deflation).
 So in nominal GDP calculation, inflation or deflation affects the total
GDP. For example, the nominal GDP of country B has given in the
following table.

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 NOMINAL GDP
Here in order to calculate the nominal GDP for each year the total value of products have to
be computed in the following way.

  Banana Apple
Year Price Quantity Price Quantity
1990 1 5 6 5
1991 2 5 6 5

 Nominal GDP= Current Year Price x Current Year Output

 Nominal GDP for 1990: 1 x 5 + 6 x 5 = 35 

 Nominal GDP for 1991: 2 x 5 + 6 x 5 = 40

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 NOMINAL GDP
Here in order to calculate the nominal GDP for each year the total value of products have to
be computed in the following way.

 In the above table the market value of goods and services produced
by country ‘B’ has increased but output has not increased.
 So the above growth in the GDP of country ‘B’ is not due to rise in
the output but only due to inflation and the true picture of the GDP
has not reflected in the calculation. This is the reason why the
concept of Real GDP came into existence

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 REAL GDP

 Real GDPs measures what a country has really produced. Thus, it

shows the original or true picture about the output of a country.
 It is calculated using the prices of a base year. Real GDP is
corrected for inflation.

 Real GDP = Base Year Price x Current Year Output

 For example, if 1990 were chosen as the base year, then real GDP
for 1995 is calculated by taking the quantities of all goods and
services purchased in 1995 and multiplying them by their 1990
prices.

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 REAL GDP
Practical Exercise

 1. Compute Real GDP in each year, using 2005 as the base year.
  Orange Dates

Year Price Quantity Price Quantity

2005 OMR 10 400 OMR 2.00 1000

2006 11 500 2.50 1100

2007 12 600 3.00 1200

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 REAL GDP
Practical Exercise

  Orange Dates
Year Price Quantity Price Quantity
2005 OMR 10 400 OMR2.00 1000
2006 11 500 2.50 1100
2007 12 600 3.00 1200

 Real GDP= Base Year Price x Current Year Output

 Real GDP for 2005: OMR 10 x 400 + OMR 2 x 1000 = 6,000

 Real GDP for 2006: (10 x 500) + (2 x 1100) = 7,200
 Real GDP for 2007: (10 x 600) + (2 x 1200) = 8,400
 Here the Real GDP has been calculated by using 2005 as the base
year. So the price changes in goods were not affected in the total GDP.
That means, it is corrected for inflation.
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 Real GDP
Percentage changes in the Real GDP can be calculated by using the following
formula: -

Percentage Changes in GDP = New GDP Value ― Old GDP Value X 100

Old GDP Value

Percentage Changes in Real GDP for 2005: OMR 6,000 = Nil

Percentage Changes in Real GDP for 2006

= OMR ((7200 - 6000) /6000 ) X 100 = 20 %

Percentage Changes in Real GDP for 2007

= OMR ((8400-7200) /7200 ) X 100 = 16.67%

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CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 53
CHAPTER 2 THE CIRCULAR FLOW OF INCOME
REVIEW QUESTIONS
1) Define households and firms.
2) Explain circular flow of income through Simple Economy Model.
3) What is the difference between real flow and money flow?
4) What is National Income?
5) Distinguish between GDP and GNP.
6) Why measuring national income is important? Discuss.
7) Explain the different methods of measuring national income.
8) What are the problems in calculating national income of a country?
9) What is the difference between Real GDP and Nominal GDP?

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CHAPTER 2 THE CIRCULAR FLOW OF INCOME

REVIEW QUESTIONS
 10) Compute Nominal and Real GDP in each year and find
percentage changes in the GDP. (Use 2001 as base year)

•
Orange Dates
 
Year Price Quantity Price Quantity
2001 6 100 1.50 800
2002 7 150 2.00 900
2003 8 200 2.50 1000

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 REFERENCES
 [Link]
[Link]?
docID=346118&query=macro+economics
 [Link]
[Link]?
docID=1144063&query=macro+economics

CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 56