UNIT 1 : National Income and Related Aggregates

Chapter 1
Circular Flow of Income
 Meaning of Macroeconomics
• Macro – Makros (Greek word) – Large – It deals with the overall
performance of the economy.

• Macroeconomics is defined as that branch of economics which

studies economic issues or economic problems at the level of
economy as a whole.

• It studies the behaviour of aggregates of the economy as a whole.

• Its main tools are aggregate demand and aggregate supply.

 Emergence of Macroeconomics
• Macroeconomics, as a separate branch of economics, emerged after the
British economist John Maynard Keynes published his book “The General
Theory of Employment, Interest and Money” in 1936.

• The Great Depression of 1929 – decrease in output and employment in Europe

and North America (other countries also) – Unemployment rate increased
from 3% to 25% and aggregate output in USA fell by 33%.

• Keynes book – “The General Theory of Employment, Interest and Money” –

interdependence of different sectors – macroeconomics emerged.

• Book – “The Economic Consequences of the Peace” in 1919.

 Difference between Microeconomics and Macroeconomics
Basis Microeconomics Macroeconomics
Meaning Microeconomics is that part of Macroeconomics is that part of
economic theory which studies economic theory which studies
the behaviour of individual the behaviour of aggregates of
units of an economy. the economy as a whole.
Tools Demand and supply. Aggregate demand and
aggregate supply.
Objective To determine the price of a To determine income and
commodity or factors of employment level of the
production. economy.
Degree of Limited degree of aggregation. Highest degree of aggregation.
Aggregation
Basic It assumes all macro variables It assumes that all the micro
Assumptions to be constant. variables are constant.
Other name Price Theory Income and Employment Theory
Examples Individual output, price of a National Income, General price
commodity, individual income. level, National output
 Circular Flow of Income

(i) Factors of Production

Household Sector Producer Sector

(iii) Expenditure on the purchase of goods

and services produced by the firms

(ii) Factor Payments

Introduction –
• Firms produce goods and services with collective efforts of factors of
production supplied by the household sector.

• Firms make payment to the factors of production in the form of rent, wages,
interest and profit (known as factor income).

• The household sector spend this money on the purchase of goods and
services produced by the firms.

Meaning –
It refers to the cycle of generation of income in the production process, its
distribution among the factor of production and finally, its circulation from
households to firms in the form of consumption expenditure on goods and
services produced by them.
Production Income
Phase Phase
(Generation (Distribution
of Income) of Income)

Expenditure Phase
(Disposition of
Income)
1. Production Phase (Generation Phase): Production phase means the process
of value addition by the producing sector. Producing sector purchases factors
of production (land, labour, capital and entrepreneurship) from the
households who are the owners of factors of production.

2. Distribution Phase: Household sector gives factor services to producer sector.

In return the household sector get factor payments: rent, salary and wages,
interest on capital and profit for entrepreneurship. Here, value addition is
converted into factor income.

3. Disposition Phase: In this phase, the income received by the factors of

production, is spent on the goods and services produced by the firms.
Consumption and investment expenditure generate demand for goods and
services.
 Stock and Flow

Stock: Stock variable refers to that variable, which is measured at a

particular point of time. Stock variables are not time dimensional.
For example: Wealth, Population of a country, Bank deposits, capital,
money supply, etc.

Flow: Flow variable refers to that variable, which is measured over a

period of time. Flow variables are time dimensional.
For example: National Income, Capital formation, interest on capital,
profits, change in stock, etc.
 Difference between Stock and Flow

Basis Stock Flow

Meaning Stock is measured at a Flow is measured over a
particular point of time. period of time.
Time It does not have a time It has a time dimension.
Dimension dimension.
Nature of It is a static concept. It is a dynamic concept.
Concept
Examples Population of country as Number of births during the
on 31st March. 2025. year 2024.
Classify the following as Stock and Flow:
1. Losses
2. Profit
3. National Income during the financial year 2023-24.
4. Capital
5. Balance in a bank account
6. Wealth
7. Gross Domestic Product
8. Net Investment
9. Value of Inventories as on 31st March, 2025
10. Transactions in money
Q. Identify which of the following is a flow variable:
i. Inventory ii Wealth iii Income iv Change in Inventories

Alternatives:
a) (i) and (iii) only
b) (ii) and (iv) only
c) (iii) and (iv) only
d) (i) and (ii) only
 Types of Circular Flow
(i) Factors Services (Real Flows/Physical Flows)

(iii) Factor Payments (Money Flows/Nominal Flows)

(iv) Expenditure on Goods and Services

(Money Flows/Nominal Flows)

Households Firms

(ii) Goods and Services(Real Flows/Physical Flows)

Real Flows: It refers to the flow of factor services from households to
firms and the corresponding flow of goods and services from firms to
households.

• Also known as ‘Physical Flow’.

• It determines the magnitude of the growth process in an economy.

Goods and Services sold by the Firms

Household Sector Producer Sector

Factor Services rendered by Households

Money Flows: It refers to flow of factor payments from firms to
households for their factor services and corresponding flow of
consumption expenditure from households to firms for purchase of
goods and services produced by the firms.

• Also known as ‘Nominal Flow’.

Factor Payments (Rent, wages, Interest and Profit)

Household Sector Producer Sector

Consumption Expenditure on goods and services

 Difference between Real Flow and Money Flow
Basis Real Flow Money Flow
Meaning It is the flow of goods and It is the flow of money
services between firms and between firms and
households. households.
Kind of It involves exchange of goods It involves exchange of
exchange and services. money.
Difficulty in There may be difficulties of There is no such difficulty
exchange barter system in exchange of in case of money flow.
goods and factor services.
Alternative Physical Flow Nominal Flow
Name
 Four Sectors of the Economy

Household Producer Government The External

Sector Sector Sector Sector
1. Household Sector: It includes consumers of goods and services.
They are owners of factors of production. They supply factor
services like land, labour, capital and entrepreneur and receive
income in return in the form of rent, wages, interest and profit
respectively.

2. Producer Sector (Firms): It includes all producing units in the

economy. They hire factors of production from the households.
3. Government Sector: It includes government as a welfare agency
(maintaining law and order, defence and other services of public
welfare) and government as a producer (it produces goods and
services in public sector enterprises).
4. The External Sector (Rest of the World): It includes activities
related to export and import of goods and the flow of capital
between the domestic economy and other countries of the world.
Also known as ‘foreign sector’.
 Circular Flow in a Simple Economy (Two-Sector Economy)
Closed Economy and Open Economy:
1. Closed Economy has no economic relations with rest of the world. A
closed economy has 3 sectors – Household Sector, Producing Sector and
Government Sector.

2. Open Economy has economic relations with rest of the world. An open
economy has 4 sectors – Household Sector, Producing Sector,
Government Sector and Foreign Sector.
A simple economy assumes the existence of only two sectors – household
sector & firm sector.
1. Households are the owners of factor of production and consumers of
goods and services.
2. Firms produce goods and services and sells them to the households.
Assumptions:
1. There are only 2 sectors in the economy – Households & Firms. There is no
government and foreign sector.
2. Household sector supplies factor services only to firms and firms hire
factor services only from households.
3. Firms produce goods and services and sells their entire output to the
households.
4. Households spend their entire income on consumption of goods and
services.
5. There are no savings in the economy, neither the households save their
incomes, nor the firms save from their profits.
 Factor Services (land, labour, capital & entrepreneur)

Consumption expenditure on goods & services

Household Producer
Sector Sector

Factor payments (rent, wages, interest & profit)

Goods and Services

1. The outer loop shows the real flow, flow of factor services from
household sector to firms and the corresponding flow of goods and
services from firms to households.

2. The inner loop shows the money flow, flow of factor payments
from firms to households and the corresponding flow of
consumption expenditure from households to firms.
Conclusions:
1. Total Production of goods and services by Firms = Total
Consumption of goods and services by Households.

2. Factor Payments by firms = Factor Incomes of households.

3. Factor Income of households = Consumption expenditure by

households.

4. Real Flows = Money Flows.

 Circular Flow in a Two-Sector Economy (with Financial market)

Factor Services (land, labour, capital & entrepreneur)

Consumption expenditure on goods & services

Savings
Household Financial Producer
Savings Market
Sector Sector
Borrowings
Factor payments (rent, wages, interest & profit)

Goods and Services

 Role of Government in an Economy

1. Government collects taxes from households and firms.

2. Government makes transfer payments to the households and

provides subsidies to the firms.

3. Government makes payment for purchase of goods and

services from the firms.

4. Government saves and borrows money with the help of

financial market.
 Leakages and Injections
Leakages refers to withdrawal of money from the circular flow. When
households and firms save a part of their incomes, it leads to a
leakage from the circular flow of income. Leakage or withdrawal
refers to that part of income, which does not pass through the
circular flow of income. Leakages reduces the flow of income.

Injections refers to introduction of income into the circular flow.

When households and firms borrow from external sources like
financial institutions, it adds to their income. Injections increase the
flow of income.
 Micro-Macro Paradox
• What is logical at micro level may not be logical at macro level. It means, an
act which is beneficial for an individual, may prove to be harmful for the
economy as a whole.

• For example, at an individual level, saving is a virtue. It is good for his future
prosperity. But if all the people in an economy save more, demand for goods
and services will decrease. As a result of decrease in demand, investment,
production and employment level will fall. The economy may be driven in the
state of poverty and depression.
Q. Flow of goods and services and factors of production across
different sectors in a barter economy is known as:
a. Circular Flow
b. Real Flow
c. Monetary Flow
d. Capital Flow
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