Circular Flow and Measurement of National Income

Learning outcomes
After studying this unit, you should be able to:
Understand national income
Importance of national income
Define national income accounting
Analyze the circular flow of income
Discover the flow of income in various sectors
Understand different sectors

We have already explained that national income is a flow. This flow can be expressed either in
terms of goods and services or in the form of money income. The flow is also known as the real
flow. The flow of money income is known as the money flow
Flow of Income in a Two-sector Economy
We will explain the flow of income in an economy by taking a model of simple economy in which
only two sectors operate viz., household sector and producer's sector or firms, Real flow and
money flow of income are shown in Figure. The upper loop in Figure shows the real flow in the
economy. Households supply factor services to the firms'. Business firms by utilising the factor
services produce goods and services. Firms provide goods and service_ to households as a
reward of their factor services, i.e., goods and services flow from firms to households; this
constitutes the real flow in the economy.

Figure of flow of income
In the modern economies factor payments are not made in kind hilt in terms of money. Factorowners, i.e., households, receive their rewards in the form of money, as shown in the lower loop
in Fig. 7.1. household utilizes this money to purchase goods and services produced by the firms.
Thus money flows from firms to households and again back to the firms. Since the income flow in
a circular way between the firms and households, this flow is also known as “Circular flow of

Inclusion of Saving and Investment in the Flow of Income
The above simplified illustration of the circular flow of income has been based on a few
assumptions, viz.,
(a) whatever income the households receive, the whole of it is spent on consumption
expenditure, and
(b) whatever income the firms get by selling goods and services, the whole of it is spent in
making factor payments.
In real life, however, households and firms save a part of their earnings. These savings are
pooled together in: the capital market. Capital market refers to those institutions which transact in
loan able funds; such as banks insurance companies, etc. Savings accumulated in the capital
market are utilized by firms for investment purposes, as shown in Figure. Thus, the circular flow
of income goes on, moving continuously with no disruption. Saving comes back to the economy
in the form of investment. In the ultimate analysis, savings and amount of investment in an
economy will always be equal.

Government Sector and the Flow of Income
Government plays a significant role in the economic life of any country. Government acts both as
a consumer and a producer in the modern economies. It has its own sources of income, and also
it has to incur expenditure in a number of ways. A government collects taxes both from the firms
and the households. A tax is a compulsory payment levied by any authority without any regard to
the service rendered by it. Tax is the major source of income of modern governments. A
government spends the income so accumulated on a number of activities, which are so designed
as to benefit both the households and the firms.
For example, government may undertake to operate a number of collective services for the use of
the community. This type of activity will satisfy the communal needs of the society. Likewise, it is
also possible that the government may incur expenditure to render some services to the firmsector ;e.g..the Government may decide to subsidise the production of a' few important
commodities.' Similarly, govenment may purchase goods and services from the firm-sector for the
collective use of the society. With the introduction of the government sect<;>r, the circular I flow'
of income will look like as in the givrn Figure.

Figure of government sector flow of income
It is clear from the above Figure that whatever the government takes out from the flow of income,
it pumps back the same in the form of public or State expenditure, and thus, the circular flow of
income goes on moving continuously.
Give some examples of government sectors--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------Introduction of Foreign Trade
We can further' complicate our model of/the circular flow of income in an economy by including
yet another sector; this time we will consider the effect of foreign trade on the circular flow.
Foreign trade is the characteristic feature of the modern open economies. Foreign 'trade implies
two transactions, viz., exports and imports. Goods and services are exported from one country to
another, and similarly imports also come to a country from different sources. Firms and
government receive money value in the form of payments for exports, and make payments
abroad for imports, as can be seen from Figure.
Thus, a part of income which is sent abroad towards payments for imports comes back to the flow
in the form of receipts for exports.
To sum up, income is generated in the producing sector of the economy; it flows between the
different sectors making, the productive process a continuous activity. This size of the flow willvary depending upon the fact whether the economy is a growing or a static one. In a growing
economy, level of economic activity will go on increasing, made possible by investment, which represents a surplus of production over current consumption. As investment increases ,
productive potential of the economy will increase, resulting in more production and higher, consumption, and also more saving. Government transactions will- also increase, as its revenue from
sources like direct and indirect taxes will go up ;similarly, it will be called upon to perform more
functions necessitating higher expenditure. Likewise, the 'economy's'externaj.tratlsaClt0'nS may.
:a 0 increase. But if we stick to our assumption that exports and imports balance in value, and
that the net receipts on account. of external transactions amount to zero,' these transactions will
not affect the size of the 'flow, at least not directly. although it may create conditions that lead to
more reduction in the economy, and thus set in a chain 'sequence which inflates the size of the

flow. In a static economy, on the contrary, the size of flow will remain unchanged; the same
amount of income will keep on flowing between the different sectors of the economy.

Importance of National Income Estimates
National income is a flow expressed in terms of total output. The -estimates relating to the flow of
total output in an economy are being used by economists, policy-makers and decision-makers for
varied purposes, e.g., for inter-country comparisons, for temporal comparisons, for measuring the
relative sigil1ficance of the different sectors of the economy. Some of the I important uses of the
national income estimates are as, , follows:
first the national account were prepared with a view to helping the public authorities in formulating
their economic policies. the use of the national account to excert active pressure on economic
development is still of great importance, especially in those developing economies which have
adopted economic planning. In such an economy, national income statistics facilitate the
formulation of plans and fixing of target& of development. Besides individual programmes and
projects, a plan il1.corpora,tes an aggregate .Picture .consisting of saving, income, consumption,
investment and employment. For this overall aspect we' do need national income and allied
estimates. Further, these estimate_ also facilitate the evaluation and assessment of development
programmes. To what extent have the overall targets been achieved, and to what extent do they
need a. revision, 'are the problems the answer to which is indicated by national income estimates.
Secondly, the use of the national accounts for the study of the economy and appropriate
decision-making has also spread to the business world, business firms take great interest in the
study of their share in the aggregate production of industry and in the total national production.
They also find in the accounts information about the distribution of national expenditure, i.e.,
which markets are expanding and which are contracting. This helps the business" firms formulate
their business strategy.
Thirdly, the income part of the accounts is of particular interest to trade unions and labour
organisations. From these accounts, these organisations find the distributions of the shares of
income and the correlation of these shares with production.
Thirdly, the income part of the accounts is of particular interest to trade unions and labour
organisations. From these accounts, these organisations find the distributions of the shares of
income and the correlation of these shares with production.
Fifthly, national income estimates are used to compare the international level of welfare and the
stage of growth of various economies.
Sixthly, the national accounts also throw light on the structural changes in an economy. They
provide information on the relative importance of the different producing sectors, as also
regarding the distribution of income among the various classes and regions and the consumption
pattern of the people.
Finally, the national accounts have been found to be useful in the teaching of economics. Basic
economic concepts and identities are grasped more easily and made clearer by following, the

inter-relationship between the various aggregates and accounts. Prominent economists have
written text-books using the national accounts approach as a method for explaining and analysing
economic activity.


National Income
National income is a flow expressed in
terms of total output.


Production process
Production process is a Continuous one
in which goods and services are
produced with the help of various
factors of production like our, land,
capital, enterprise and so on.


Approaches to national
income measurements
There are three approaches to national
income measurements:
1. Income method or factor income in
the production process
2. Product method or value added in
production process
3. Final expenditure method


National income
National Income Accounting represents
the tools and methods by which
economists and policy-makers measure
economic activity and economic growth
over time.
The aim of national income accounting is to
place a money value on this year's output.


Circular flow of national


Methods of calculating
national income
There are three methods of calculating
national income:
Income Method
Expenditure Method
Output Method



1) Define National Income?
-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------2) Short notes on:
a) National Income Accounting:---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------b)Circular Flow of Income:--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

c) Production Process:-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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