1

ow is the Economy Doing? How Does One Tell?

The 1990s were boom years for the U.S. economy. The late 2000s, from 2007 to 2014
were not. What causes the economy to expand or contract? Why do businesses fail when they
are making all the right decisions? Why do workers lose their jobs when they are
hardworking and productive? Are bad economic times a failure of the market system? Are
they a failure of the government? These are all questions of macroeconomics, which we will
begin to address in this chapter. We will not be able to answer all of these questions here, but
we will start with the basics: How is the economy doing? How can we tell?

The macro economy includes all buying and selling, all production and consumption;
everything that goes on in every market in the economy. How can we get a handle on that?
The answer begins more than 80 years ago, during the Great Depression. President Franklin
D. Roosevelt and his economic advisers knew things were bad—but how could they express
and measure just how bad it was? An economist named Simon Kuznets, who later won the
Nobel Prize for his work, came up with a way to track what the entire economy is producing.
The result—gross domestic product (GDP)—remains our basic measure of macroeconomic
activity. In this chapter, you will learn how GDP is constructed, how it is used, and why it is
so important.

Chapter Objectives

Introduction to the Macroeconomic Perspective

In this chapter, you will learn about:

 Measuring the Size of the Economy: Gross Domestic Product

 Adjusting Nominal Values to Real Values
 Tracking Real GDP over Time
 Comparing GDP among Countries
 How Well GDP Measures the Well-Being of Society

Macroeconomics focuses on the economy as a whole (or on whole economies as they

interact). What causes recessions? What makes unemployment stay high when recessions are
supposed to be over? Why do some countries grow faster than others? Why do some
countries have higher standards of living than others? These are all questions that
macroeconomics addresses. Macroeconomics involves adding up the economic activity of all
households and all businesses in all markets to get the overall demand and supply in the
economy. However, when we do that, something curious happens. It is not unusual that what
results at the macro level is different from the sum of the microeconomic parts. Indeed, what
seems sensible from a microeconomic point of view can have unexpected or
counterproductive results at the macroeconomic level. Imagine that you are sitting at an event
with a large audience, like a live concert or a basketball game. A few people decide that they
want a better view, and so they stand up. However, when these people stand up, they block
the view for other people, and the others need to stand up as well if they wish to see.
Eventually, nearly everyone is standing up, and as a result, no one can see much better than
before. The rational decision of some individuals at the micro level—to stand up for a better
 2

view—ended up being self-defeating at the macro level. This is not macroeconomics, but it is
an apt analogy.

Macroeconomics is a rather massive subject. How are we going to tackle it? Figure

2 illustrates the structure we will use. We will study macroeconomics from three different
perspectives:

1. What are the macroeconomic goals? (Macroeconomics as a discipline does not have
goals, but we do have goals for the macro economy.)
2. What are the frameworks economists can use to analyze the macroeconomy?
3. Finally, what are the policy tools governments can use to manage the macroeconomy?

Fi
gure 2. Macroeconomic Goals, Framework, and Policies. This chart shows what
macroeconomics is about. The box on the left indicates a consensus of what are the most
important goals for the macro economy, the middle box lists the frameworks economists use
to analyze macroeconomic changes (such as inflation or recession), and the box on the right
indicates the two tools the federal government uses to influence the macro economy.

Goals

In thinking about the overall health of the macroeconomy, it is useful to consider three
primary goals: economic growth, low unemployment, and low inflation.

 Economic growth ultimately determines the prevailing standard of living in a country.

Economic growth is measured by the percentage change in real (inflation-adjusted) gross
domestic product. A growth rate of more than 3% is considered good.
 Unemployment, as measured by the unemployment rate, is the percentage of people in
the labor force who do not have a job. When people lack jobs, the economy is wasting a
precious resource-labor, and the result is lower goods and services produced. Unemployment,
however, is more than a statistic—it represents people’s livelihoods. While measured
unemployment is unlikely to ever be zero, a measured unemployment rate of 5% or less is
considered low (good).
 Inflation is a sustained increase in the overall level of prices, and is measured by the
consumer price index. If many people face a situation where the prices that they pay for food,
shelter, and healthcare are rising much faster than the wages they receive for their labor, there
will be widespread unhappiness as their standard of living declines. For that reason, low
inflation—an inflation rate of 1–2%—is a major goal.

Frameworks
 3

As you learn in the micro part of this book, principal tools used by economists are theories
and models (see Welcome to Economics! for more on this). In microeconomics, we used the
theories of supply and demand; in macroeconomics, we use the theories of aggregate
demand (AD) and aggregate supply (AS). This book presents two perspectives on
macroeconomics: the Neoclassical perspective and the Keynesian perspective, each of which
has its own version of AD and AS. Between the two perspectives, you will obtain a good
understanding of what drives the macroeconomy.

Policy Tools

National governments have two tools for influencing the macroeconomy. The first is
monetary policy, which involves managing the money supply and interest rates. The second
is fiscal policy, which involves changes in government spending/purchases and taxes.

Each of the items in Figure 2 will be explained in detail in one or more other chapters. As you
learn these things, you will discover that the goals and the policy tools are in the news almost
every day.

Lesson summary: Introduction to Macroeconomics

This article summarizes the learning objectives and essential knowledge for the lesson on
Scarcity. Here you will find key terms, key concepts, common misperceptions, and
discussion questions to help you review what you have learned.
If you want to sum up what economics means, you could do so with the following statement:

Individuals and societies are forced to make choices because most resources are scarce.

Economics is the study of how individuals and societies choose to allocate scarce resources,
why they choose to allocate them that way, and the consequences of those decisions.

Scarcity is sometimes considered the basic problem of economics. Resources are scarce

because we live in a world in which humans’ wants are infinite but the land, labor, and
capital required to satisfy those wants are limited. This conflict between society’s unlimited
wants and our limited resources means choices must be made when deciding how to allocate
scarce resources.

Any economic system must provide society with a means of making choices that answer
three basic questions:

 What will be produced with society’s limited resources?

 How will we produce the things we need and want?
 How will society’s output be distributed?
 4

Key Terms

Term Definition

The study of how individuals and societies choose to allocate scarce

economics resources.

The fact that there is a limited amount of resources to satisfy

scarcity unlimited wants.

Also called the factors of production; these are the land (natural

resources such as minerals and oil), labor (work contributed by
humans), capital (tools, equipment, and facilities), and
entrepreneurship (the capacity to organize, develop, and manage a
economic business) that individuals and businesses use in the production of
resources goods and services.

Graphical and mathematical tools created by economists to better

models understand complicated processes in economics.

ceteris paribus A Latin phrase meaning "all else equal".

Some entity making a decision; this can be an individual, a

agent household, a business, a city, or even the government of a country.

Rewards or punishments associated with a possible action; agents

incentives make decisions based on incentives.

An agent is "rational" if they use all available information to choose

rational decision an action that makes them as well off as possible; economic models
making assume that agents are rational.

Analytical thinking about objective facts and cause-and-effect

relationships that are testable, such as how much of a good will be
positive analysis sold when a price changes.

normative Unlike positive analysis, normative analysis is subjective thinking

analysis about what we should value or a course of action that should be
 5

Term Definition

taken, such as the importance of environmental factors and the

approach to managing them.

the study of the interactions of buyers and sellers in the markets for
microeconomics particular goods and services

The study of aggregates and the overall commercial output and

health of nations; includes the analysis of factors such as
macroeconomics unemployment, inflation, economic growth and interest rates.

Measures such as the unemployment rate, rate of inflation, and

national output that summarize all markets in an economy, rather
economic than individual markets; economic aggregates are frequently used as
aggregates measures of the economic performance of an economy.

Models and graphs

Economics is a social science. This means that economists, in their study of human
interactions, use models to simplify, analyze, and predict human behavior. Models include
graphs and mathematical models.

The purpose of these graphs and mathematical models is to simplify the many interactions
that occur in an economy. In their use of models, economists usually make the assumption,
when analyzing the effect of a particular change on a market or on a nation’s economy, that
all else is held constant. The term we use for “all else equal” is the Latin expressions, ceteris
paribus.

Another assumption economists make is that economic agents are rational and have

an incentive to make decisions that are always in their own self-interest. While in reality
human beings often act irrationally, by assuming people, businesses, governments, and other
agents are rational decision-makers, and by assuming ceteris paribus, economists attempt to
establish laws and make predictions about how human interactions will affect society.
 6

When thinking about economic problems, we can use either positive analysis or normative

analysis. Positive analysis is objective, fact-based, and cause-and-effect thinking about
problems. When economists disagree it is typically due to different normative analysis. When
using normative analysis, the focus is on what should happen or how desirable one action is
compared to a different action.

The study of economics is sometimes broken down into two

disciplines: microeconomics and macroeconomics. Microeconomics examines the
interactions of buyers and sellers in individual markets for goods and services, the
competitive structure of markets, and the markets for resources. Macroeconomics examines
the interactions and behavior of entire nations' economies, such as why recessions occur,
what causes economic growth, and how countries can benefit from specialization and trade.

Common Misperceptions

 Economics is not the study of stock markets, money, or how to run a business.
Although many new students believe they will be learning about these concepts, economics is
a social science that seeks to better understand and predict human interactions; unlike
business and finance, which focus on how to manage a business organization and invest
money in a way to earn the highest return for investors.

 One essential assumption made in most economic analysis is that all humans are
rational and will make choices based on what is always in their best interest. In the real
world, obviously, people, businesses, and even entire societies can be highly irrational.

 Just because a decision is "irrational" in the economic sense, that doesn't mean that it
is inherently wrong, bad, or lesser than what an economist would call a "rational" decision. In
fact, the field of Behavioral Economics seeks to understand better the many reasons humans
choose to make economically "irrational" choices in their decision making.

 One of the four economic resources that societies must decide how to allocate
is capital. When people use the word capital in everyday conversation, many people are
referring to money or “financial capital.” In economics, capital is defined as the already-
 7

produced goods (tools, machinery, equipment, and physical infrastructure) that are used in
the production of other goods or services. A robot on a car factory floor is defined as capital
in economics; money you borrow to start your own business is not.

Discussion questions

 Victorian historian Thomas Carlyle once called economics the "dismal science"
because he believed it obsessively focused on the scarcity of resources. What does the field of
economics provide society that other sciences such as chemistry, biology and physics cannot?

 Using at least three key terms from this lesson, explain how scarcity affects you in
your everyday life.

 What are the three basic economic questions? How have different societies that you
know about or have studied in other classes attempted to answer these questions?

 Relationship Between Macro and Micro Economics:

 Economics is a branch of science that deals with the study of how the limited
resources are utilized in production of goods which are to be distributed for
consumption by consumers. Microeconomics and macroeconomics are the branches
of economics.
 Answer and Explanation:
 Microeconomics and macroeconomics are related and complementary to each other.
The production and consumption level in the entire economy is the sum of all the
individual levels of production and consumption. All the decisions made at the
individual level are noticed at the entire level. The performance at the micro level is
evidenced at the macro level.
 Microeconomics involves the study of individual or single parts of a particular
economy. The way single persons or firms or businesses uses the resources which are
limited in the production of goods and services for distribution and consumption by
consumers is analyzed in microeconomics. Macroeconomics involves the study of the
entire economy. The way the limited resources are utilized by a whole economy in
production of goods and services for consumption is analyzed in macroeconomics.

Microeconomics vs. Macroeconomics: What's the Difference?

Microeconomics vs. Macroeconomics: An Overview

Economics is divided into two different categories: microeconomics and macroeconomics.
Microeconomics is the study of individuals and business decisions, while macroeconomics
looks at the decisions of countries and governments.
 8

While these two branches of economics appear to be different, they are actually
interdependent and complement one another since there are many overlapping issues between
the two fields.

KEY TAKEAWAYS

 Microeconomics studies individuals and business decisions, while macroeconomics

analyzes the decisions made by countries and governments.
 Microeconomics focuses on supply and demand, and other forces that determine price
levels, making it a bottom-up approach.
 Macroeconomics takes a top-down approach and looks at the economy as a whole,
trying to determine what the economy should look like.
 Investors can use microeconomics in their investment decisions, while
macroeconomics is an analytical tool mainly used to craft economic and fiscal policy.
Microeconomics
Microeconomics is the study of decisions made by people and businesses regarding the
allocation of resources and prices of goods and services. It also takes into account taxes and
regulations created by governments.

Microeconomics focuses on supply and demand and other forces that determine the price
levels in the economy. It takes what is referred to as a bottom-up approach to analyzing the
economy. In other words, microeconomics tries to understand human choices and resource
allocation.

Having said that, microeconomics does not try to answer or explain what forces should take
place in a market. Rather, it tries to explain what happens when there are changes in certain
conditions.

For example, microeconomics examines how a company could maximize its production and
capacity so that it could lower prices and better compete in its industry. A lot of
microeconomic information can be gleaned from the financial statements.

Microeconomics involves several key principles including (but not limited to):

 Demand, Supply, and Equilibrium: Prices are determined by the theory of supply

and demand. Under this theory, suppliers offer the same price demanded by
consumers in a perfectly competitive market. This creates economic equilibrium.
 Production Theory: This is the study of production.
 Costs of Production: According to this theory, the price of goods or services is
determined by the cost of the resources used during production.
 Labor Economics: This principle looks at workers and employers, and tries to
understand the pattern of wages, employment, and income. 

The rules in microeconomics flow from a set of compatible laws and theorems, rather than
beginning with empirical study.

Volume 75%
 
 9

Microeconomics Vs. Macroeconomics

Macroeconomics
Macroeconomics, on the other hand, studies the behavior of a country and how its policies
affect the economy as a whole. It analyzes entire industries and economies, rather than
individuals or specific companies, which is why it's a top-down approach. It tries to answer
questions like "What should the rate of inflation be?" or "What stimulates economic growth?"

 
Macroeconomics examines economy-wide phenomena such as gross domestic product (GDP)
and how it is affected by changes in unemployment, national income, rate of growth, and
price levels.
Macroeconomics analyzes how an increase or decrease in net exports affects a nation's capital
account, or how GDP would be affected by the unemployment rate.

Macroeconomics focuses on aggregates and econometric correlations, which is why it is used

by governments and their agencies to construct economic and fiscal policy. Investors of
mutual funds or interest-rate-sensitive securities should keep an eye on monetary and fiscal
policy. Outside of a few meaningful and measurable impacts, macroeconomics doesn't offer
much for specific investments.

John Maynard Keynes is often credited as the founder of macroeconomics, as he initiated the

use of monetary aggregates to study broad phenomena.1 Some economists dispute his theory,
while many of those who use it disagree on how to interpret it.

Investors and Microeconomics vs. Macroeconomics

Individual investors may be better off focusing on microeconomics than macroeconomics.
There may be some disagreement between fundamental (particularly value) and technical
investors about the proper role of economic analysis, but it is more likely that
microeconomics will affect an individual investment proposal.

Warren Buffett famously stated that macroeconomic forecasts don't influence his investing
decisions. When asked about how he and business partner Charlie Munger choose
investments, Buffett responded, "Charlie and I don’t pay attention to macro forecasts. We
have worked together now for 50 years and can’t think of a time we made a decision on a
company where we’ve talked about macro."2 Buffett also referred to macroeconomic
literature as "the funny papers."3

John Templeton, another famously successful value investor who died in 2008 at the age of
95, shared a similar sentiment. "I never ask if the market is going to go up or down because I
don't know. It doesn't matter. I search nation after nation for stocks, asking: 'where is the one
that is lowest priced in relation to what I believe it's worth?'" said Templeton. 4

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 10

Differences and Similarities between Microeconomics and Macroeconomics

 Microeconomics and Macroeconomics

There are differences between microeconomics and macroeconomics, although sometimes
it may be difficult to separate them. Microeconomics is concerned with the individual
behavior of an enterprise to know the volume of production that maximizes profits for an
enterprise. In particular, the microeconomics focuses on supply and demand patterns, pricing
and production in individual markets. Macroeconomics focuses on the study of the economy
as a whole, not just specific companies but an entire industry. Therefore, the study examines
how factors such as GDP, inflation, unemployment and other factors affect the economy as a
whole. Any change in the unemployment rate, for example, may have a significant impact on
the country's GDP.
These two branches of economics are of vital importance and play an important role in
shaping the fate of countries and the destiny of nations at the local and global levels. In this
article, we will try to review the differences and similarities between microeconomics and
macroeconomics.

Microeconomics:
 Microeconomics is a branch of economics that deals with the economic behavior of each
unit of economy, such as individuals, companies or industrial sectors, as well as the factors
affecting individual choices, the impact of economic changes in decision-making in markets.
Microeconomics is defined as social science, which examines the consequences of
individuals' actions, especially as they relate to the nature of the impact on decisions to use
and distribute resources.
It also deals with the behavior of the consumer to know how to distribute his expenditure
among the different commodities so as to achieve maximum satisfaction within the limits of
his income.
Microeconomics focuses on the study of individual economic units and specific markets such
as the automobile or wheat market. In addition to studying how resources and prices of goods
and services are allocated and how they determine the forces of supply and demand. If we
want to take an example of microeconomics, we can say that microeconomics looks at how a
particular company can increase its production while keeping prices low overall.  

Importance of Microeconomics
The microeconomics is of great importance in the work environment that can be summarized
by the following points:

⇒Microeconomics is involved in the development of economic policies and contributes to

enhancing production efficiency and increasing welfare in society.
⇒Microeconomics contributes to the interpretation of the capitalist economic nature;
individual units make economic decisions individually.
⇒Microeconomics helps to describe the nature of the economy in institutions and the role of
individual economic units to achieve balance.
⇒Microeconomics is keen to employ the best resources; by relying on business.
⇒Microeconomics provides assistance to business economists, specifically in the area of
business forecasting.
⇒Microeconomics is used to explain trade gains, the apparent imbalance in the balance of
payments, and also to determine the international exchange rate.
 11

Elements of Microeconomics
Microeconomics consists of a set of key elements:
Supply: A quantity of a service or commodity that the merchant agrees to sell at a specified
price.
Demand: The willingness of individuals or enterprises to pay a sum of money in exchange
for services or goods within a certain period of time.
Elasticity: Elasticity is the means of determining the nature of changes in the demand for
consumer goods; because of the change in their prices, when the goods are flexible it
indicates that demand is affected by the price change, and if they are not flexible,  the
demand is not affected by the price changes.
Opportunity Cost: The financial cost that is the best value alternative to goods or services
that are an option for individuals and companies.

Macroeconomics:
Macroeconomics addresses the functioning of the economic system as a whole. It does not
focus on a specific industry but on the industry as a whole. Macroeconomics is concerned
with studying a variety of economic phenomena such as inflation, price levels, growth rate,
national income, GDP, changes in labor market conditions and the effects of exports and
imports. It focuses on trends in the economy and how the economy moves as a whole.

Importance of Macroeconomics
The importance of macroeconomics can be summarized according to the following points:

⇒Macroeconomics helps us understand the work of a complex modern economic system. It

describes how the economy performs as a whole, and how the level of national income and
employment is determined on the basis of aggregate demand and aggregate supply.
⇒Macroeconomics helps to achieve the goal of economic growth, a high level of GDP, and a
high level of employment. It analyzes the forces that determine the economic growth of the
country and explains how to reach and maintain the highest state of economic growth.
⇒Macroeconomics helps to stabilize the price level and analyze fluctuations in business
activities. It proposes policy measures to control inflation and deflation.
⇒Macroeconomics explains the factors that determine the balance of payments. At the same
time, it identifies the causes of the balance of payments deficit and proposes remedial
measures and solutions.
⇒Macroeconomics helps to solve economic problems such as poverty, unemployment,
inflation, deflation, etc., which can only be solved at the macro level.
⇒The macroeconomic study is of paramount importance in obtaining an idea of the
functioning of the economic system. It is very important to have accurate knowledge of the
behavioral pattern in the overall variables since the description of the large and complex
economic system is impossible in terms of many individual elements.
⇒Macroeconomic analysis is necessary for the correct understanding of the micro economy.
With detailed knowledge of macroeconomic action, it is possible to formulate sound
economic policies as well as coordinate international economic policies.

Macroeconomic Analysis
Macroeconomic analysis studies such indicators as the unemployment rate index, the GDP
index and the price indices, and then analyze how different sectors of the economy are
 12

interlinked to understand how economic functions work. Macroeconomic analysis also

develops models to illustrate the relationships between different factors such as consumption,
inflation, savings, investment, and international trade finance, national income, and output.
On the contrary, the microeconomics analyzes how individual agents, consumers, and firms
behave and it examines how their behavior affects quantities and prices in specific markets,
such as how macroeconomic models are used by government entities to help build and
evaluate economic policy.

Elements of Macroeconomics
There are many types of concepts and variables in macroeconomics, but there are three
central themes for macroeconomic research that is usually related to output (production),
unemployment and inflation. These three topics are very important for almost all the financial
agents such as workers, consumers, and producers. Some important elements and variables of
macroeconomics include:
 Output and income.
 Inflation and deflation.
 Unemployment.
 Growth models.
 IS-LM.
 Aggregate demand-aggregate supply.
 Fiscal policy.
 Monetary policy.

The Hottest Fields of Scientific Research

Macroeconomics is a fairly broad area, but it represents two specific areas of scientific
research. One area involves understanding the causal relationship and the consequences of
short-term fluctuations in national income, also known as the economic cycle.
The other involves the process in which the macro economy tries to understand factors that
determine long-term economic growth or increase national income.

The difference between Microeconomics and Macroeconomics

1. Microeconomics is concerned with demand and supply factors, while macroeconomics
dimming the performance of the economic situation as a whole and measuring the pace of
economic growth and change in national income.
2. Microeconomics facilitates the decision-making process of small business sectors within
the country.
3. Macroeconomics focuses on changes in unemployment rates, large industries and the
economy in general.
Business managers tend to focus on microeconomics and less focus on the macroeconomics,
while economists and policymakers tend to focus on macro and micro levels. Finally,
regardless of all the differences, the role of the macro and micro economy and their
importance should not be denied. Therefore, both are usually studied together to understand
how companies and the economy as a whole work.

The Similarities between Microeconomics and Macroeconomics

 13

Although microeconomics and macroeconomics differ from each other in their respective
areas of interest, there is a close relationship between them. Macroeconomics is based on
many principles and analyzes of microeconomics in its work and in studies of large economic
units.
The relationship between microeconomics and macroeconomics also lies in the fact that
aggregate levels of production and consumption are the result of choices made by households
and individual firms.
It is worth mentioning the microeconomics is used to study how macroeconomic changes can
affect the behavior of microeconomic units. For example, how any increase in inflation or a
change in the real exchange rate could affect the production of goods in a particular country.
For example, an increase in inflation could lead to a change in the price of raw materials for
companies, which in turn would affect the price of the final product paid by the consumer.
Here we see the obvious overlap between the branches of economics, each relying on the
other.

Conclusion
Despite the differences between microeconomics and macroeconomics and their respective
focus on a particular economic aspect, there is a strong relationship between them, where
many elements of microeconomy are used in the macroeconomy. In theory, the behavior of
microeconomic components can be explained by observing the behavior of individuals. In
addition, macroeconomics is based on the behavior of large economic units of
microeconomic principles.
National Income: Definition, Concepts and Methods of Measuring National Income

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National Income: Definition, Concepts and Methods of Measuring National Income!

Introduction:

National income is an uncertain term which is used interchangeably with national dividend,

national output and national expenditure. On this basis, national income has been defined in a

number of ways. In common parlance, national income means the total value of goods and

services produced annually in a country.

In other words, the total amount of income accruing to a country from economic activities in

a year’s time is known as national income. It includes payments made to all resources in the

form of wages, interest, rent and profits.

Contents:
 14

1. Definitions of National Income

2. Concepts of National Income
3. Methods of Measuring National Income
4. Difficulties or Limitations in Measuring National Income
5. Importance of National Income Analysis
6. Inter-Relationship among different concept of National Income
1. Definitions of National Income:

The definitions of national income can be grouped into two classes: One, the traditional

definitions advanced by Marshall, Pigou and Fisher; and two, modern definitions.

The Marshallian Definition:

According to Marshall: “The labor and capital of a country acting on its natural resources

produce annually a certain net aggregate of commodities, material and immaterial including

services of all kinds. This is the true net annual income or revenue of the country or national

dividend.” In this definition, the word ‘net’ refers to deductions from the gross national

income in respect of depreciation and wearing out of machines. And to this, must be added

income from abroad.

It’s Defects:
Though the definition advanced by Marshall is simple and comprehensive, yet it suffers from

a number of limitations. First, in the present day world, so varied and numerous are the goods

and services produced that it is very difficult to have a correct estimation of them.

Consequently, the national income cannot be calculated correctly. Second, there always exists

the fear of the mistake of double counting, and hence the national income cannot be correctly

estimated. Double counting means that a particular commodity or service like raw material or

labour, etc. might get included in the national income twice or more than twice.

For example, a peasant sells wheat worth Rs.2000 to a flour mill which sells wheat flour to

the wholesaler and the wholesaler sells it to the retailer who, in turn, sells it to the customers.
 15

If each time, this wheat or its flour is taken into consideration, it will work out to Rs.8000,

whereas, in actuality, there is only an increase of Rs.2000 in the national income.

Third, it is again not possible to have a correct estimation of national income because many

of the commodities produced are not marketed and the producer either keeps the produce for

self-consumption or exchanges it for other commodities. It generally happens in an

agriculture- oriented country like India. Thus the volume of national income is

underestimated.

The Pigouvian Definition:

A.C. Pigou has in his definition of national income included that income which can be

measured in terms of money. In the words of Pigou, “National income is that part of objective

income of the community, including of course income derived from abroad which can be

measured in money.”

This definition is better than the Marshallian definition. It has proved to be more practical

also. While calculating the national income now-a- days, estimates are prepared in

accordance with the two criteria laid down in this definition.

First, avoiding double counting, the goods and services which can be measured in money are

included in national income. Second, income received on account of investment in foreign

countries is included in national income.

It’s Defects:

The Pigouvian definition is precise, simple and practical but it is not free from criticism.

First, in the light of the definition put forth by Pigou, we have to unnecessarily differentiate

between commodities which can and which cannot be exchanged for money.

But, in actuality, there is no difference in the fundamental forms of such commodities, no

matter they can be exchanged for money. Second, according to this definition when only such
 16

commodities as can be exchanged for money are included in estimation of national income,

the national income cannot be correctly measured.

According to Pigou, a woman’s services as a nurse would be included in national income but

excluded when she worked in the home to look after her children because she did not receive

any salary for it. Similarly, Pigou is of the view that if a man marries his lady secretary, the

national income diminishes as he has no longer to pay for her services.

Thus the Pigovian definition gives rise to a number of paradoxes. Third, the Pigovian

definition is applicable only to the developed countries where goods and services are

exchanged for money in the market.

According to this definition, in the backward and underdeveloped countries of the world,

where a major portion of the produce is simply bartered, correct estimate of national income

will not be possible, because it will always work out less than the real level of income. Thus

the definition advanced by Pigou has a limited scope.

Fisher’s Definition:

Fisher adopted ‘consumption’ as the criterion of national income whereas Marshall and Pigou

regarded it to be production. According to Fisher, “The National dividend or income consists

solely of services as received by ultimate consumers, whether from their material or from the

human environments. Thus, a piano, or an overcoat made for me this year is not a part of this

year’s income, but an addition to the capital. Only the services rendered to me during this

year by these things are income.”

Fisher’s definition is considered to be better than that of Marshall or Pigou, because Fisher’s

definition provides an adequate concept of economic welfare which is dependent on

consumption and consumption represents our standard of living.

It’s Defects:
 17

But from the practical point of view, this definition is less useful, because there are certain

difficulties in measuring the goods and services in terms of money. First, it is more difficult

to estimate the money value of net consumption than that of net production.

In one country there are several individuals who consume a particular good and that too at

different places and, therefore, it is very difficult to estimate their total consumption in terms

of money. Second, certain consumption goods are durable and last for many years.

If we consider the example of piano or overcoat, as given by Fisher, only the services

rendered for use during one year by them will be included in income. If an overcoat costs Rs.

100 and lasts for ten years, Fisher will take into account only Rs. 100 as national income

during one year, whereas Marshall and Pigou will include Rs. 100 in the national income for

the year, when it is made.

Besides, it cannot be said with certainty that the overcoat will last only for ten years. It may

last longer or for a shorter period. Third, the durable goods generally keep changing hands

leading to a change in their ownership and value too.

It, therefore, becomes difficult to measure in money the service-value of these goods from the

point of view of consumption. For instance, the owner of a Maruti car sells it at a price higher

than its real price and the purchaser after using it for a number of years further sells it at its

actual price.

Now the question is as to which of its price, whether actual or black market one, should we

take into account, and afterwards when it is transferred from one person to another, which of

its value according to its average age should be included in national income?

But the definitions advanced by Marshall, Pigou and Fisher are not altogether flawless.

However, the Marshallian and Pigovian definitions tell us of the reasons influencing

economic welfare, whereas Fisher’s definition helps us compare economic welfare in

different years.
 18

Modern Definitions:

From the modern point of view, Simon Kuznets has defined national income as “the net

output of commodities and services flowing during the year from the country’s productive

system in the hands of the ultimate consumers.”

On the other hand, in one of the reports of United Nations, national income has been defined

on the basis of the systems of estimating national income, as net national product, as addition

to the shares of different factors, and as net national expenditure in a country in a year’s time.

In practice, while estimating national income, any of these three definitions may be adopted,

because the same national income would be derived, if different items were correctly

included in the estimate.

2. Concepts of National Income:

There are a number of concepts pertaining to national income and methods of measurement

relating to them.

(A) Gross Domestic Product (GDP):

GDP is the total value of goods and services produced within the country during a year. This

is calculated at market prices and is known as GDP at market prices. Dernberg defines GDP

at market price as “the market value of the output of final goods and services produced in the

domestic territory of a country during an accounting year.”

There are three different ways to measure GDP:

Product Method, Income Method and Expenditure Method.

These three methods of calculating GDP yield the same result because National Product =

National Income = National Expenditure.

1. The Product Method:

 19

In this method, the value of all goods and services produced in different industries during the

year is added up. This is also known as the value added method to GDP or GDP at factor cost

by industry of origin. The following items are included in India in this: agriculture and allied

services; mining; manufacturing, construction, electricity, gas and water supply; transport,

communication and trade; banking and insurance, real estates and ownership of dwellings

and business services; and public administration and defense and other services (or

government services). In other words, it is the sum of gross value added.

2. The Income Method:

The people of a country who produce GDP during a year receive incomes from their work.

Thus GDP by income method is the sum of all factor incomes: Wages and Salaries

(compensation of employees) + Rent + Interest + Profit.

3. Expenditure Method:

This method focuses on goods and services produced within the country during one year.

GDP by expenditure method includes:

(1) Consumer expenditure on services and durable and non-durable goods (C),

(2) Investment in fixed capital such as residential and non-residential building, machinery,

and inventories (I),

(3) Government expenditure on final goods and services (G),

(4) Export of goods and services produced by the people of country (X),

(5) Less imports (M). That part of consumption, investment and government expenditure

which is spent on imports is subtracted from GDP. Similarly, any imported component, such

as raw materials, which is used in the manufacture of export goods, is also excluded.

Thus GDP by expenditure method at market prices = C+ I + G + (X – M), where (X-M) is net

export which can be positive or negative.

 20

(B) GDP at Factor Cost:

GDP at factor cost is the sum of net value added by all producers within the country. Since

the net value added gets distributed as income to the owners of factors of production, GDP is

the sum of domestic factor incomes and fixed capital consumption (or depreciation).

Thus GDP at Factor Cost = Net value added + Depreciation.

GDP at factor cost includes:

(i) Compensation of employees i.e., wages, salaries, etc.

(ii) Operating surplus which is the business profit of both incorporated and unincorporated

firms. [Operating Surplus = Gross Value Added at Factor Cost—Compensation of

Employees—Depreciation]

(iii) Mixed Income of Self- employed.

Conceptually, GDP at factor cost and GDP at market price must be identical/This is because

the factor cost (payments to factors) of producing goods must equal the final value of goods

and services at market prices. However, the market value of goods and services is different

from the earnings of the factors of production.

In GDP at market price are included indirect taxes and are excluded subsidies by the

government. Therefore, in order to arrive at GDP at factor cost, indirect taxes are subtracted

and subsidies are added to GDP at market price.

Thus, GDP at Factor Cost = GDP at Market Price – Indirect Taxes + Subsidies.

(C) Net Domestic Product (NDP):

NDP is the value of net output of the economy during the year. Some of the country’s capital

equipment wears out or becomes obsolete each year during the production process. The value

of this capital consumption is some percentage of gross investment which is deducted from

GDP. Thus Net Domestic Product = GDP at Factor Cost – Depreciation.

 21

(D) Nominal and Real GDP:

When GDP is measured on the basis of current price, it is called GDP at current prices or

nominal GDP. On the other hand, when GDP is calculated on the basis of fixed prices in

some year, it is called GDP at constant prices or real GDP.

Nominal GDP is the value of goods and services produced in a year and measured in terms of

rupees (money) at current (market) prices. In comparing one year with another, we are faced

with the problem that the rupee is not a stable measure of purchasing power. GDP may rise a

great deal in a year, not because the economy has been growing rapidly but because of rise in

prices (or inflation).

On the contrary, GDP may increase as a result of fall in prices in a year but actually it may be

less as compared to the last year. In both 5 cases, GDP does not show the real state of the

economy. To rectify the underestimation and overestimation of GDP, we need a measure that

adjusts for rising and falling prices.

This can be done by measuring GDP at constant prices which is called real GDP. To find out

the real GDP, a base year is chosen when the general price level is normal, i.e., it is neither

too high nor too low. The prices are set to 100 (or 1) in the base year.

Now the general price level of the year for which real GDP is to be calculated is related

to the base year on the basis of the following formula which is called the deflator index:

Suppose 1990-91 is the base year and GDP for 1999-2000 is Rs. 6, 00,000 crores and the

price index for this year is 300.

Thus, Real GDP for 1999-2000 = Rs. 6, 00,000 x 100/300 = Rs. 2, 00,000 crores

(E) GDP Deflator:

 22

GDP deflator is an index of price changes of goods and services included in GDP. It is a price

index which is calculated by dividing the nominal GDP in a given year by the real GDP for

the same year and multiplying it by 100. Thus,

It shows that at constant prices (1993-94), GDP in 1997-98 increased by 135.9% due to

inflation (or rise in prices) from Rs. 1049.2 thousand crores in 1993-94 to Rs. 1426.7

thousand crores in 1997-98.

(F) Gross National Product (GNP):

GNP is the total measure of the flow of goods and services at market value resulting from

current production during a year in a country, including net income from abroad.

GNP includes four types of final goods and services:

(1) Consumers’ goods and services to satisfy the immediate wants of the people;

(2) Gross private domestic investment in capital goods consisting of fixed capital formation,

residential construction and inventories of finished and unfinished goods;

(3) Goods and services produced by the government; and

(4) Net exports of goods and services, i.e., the difference between value of exports and

imports of goods and services, known as net income from abroad.

In this concept of GNP, there are certain factors that have to be taken into consideration:

First, GNP is the measure of money, in which all kinds of goods and services produced in a

country during one year are measured in terms of money at current prices and then added

together.
 23

But in this manner, due to an increase or decrease in the prices, the GNP shows a rise or

decline, which may not be real. To guard against erring on this account, a particular year (say

for instance 1990-91) when prices be normal, is taken as the base year and the GNP is

adjusted in accordance with the index number for that year. This will be known as GNP at

1990-91 prices or at constant prices.

Second, in estimating GNP of the economy, the market price of only the final products

should be taken into account. Many of the products pass through a number of stages before

they are ultimately purchased by consumers.

If those products were counted at every stage, they would be included many a time in the

national product. Consequently, the GNP would increase too much. To avoid double

counting, therefore, only the final products and not the intermediary goods should be taken

into account.

Third, goods and services rendered free of charge are not included in the GNP, because it is

not possible to have a correct estimate of their market price. For example, the bringing up of

a child by the mother, imparting instructions to his son by a teacher, recitals to his friends by

a musician, etc.

Fourth, the transactions which do not arise from the produce of current year or which do not

contribute in any way to production are not included in the GNP. The sale and purchase of

old goods, and of shares, bonds and assets of existing companies are not included in GNP

because these do not make any addition to the national product, and the goods are simply

transferred.

Fifth, the payments received under social security, e.g., unemployment insurance allowance,

old age pension, and interest on public loans are also not included in GNP, because the

recipients do not provide any service in lieu of them. But the depreciation of machines, plants

and other capital goods is not deducted from GNP.

 24

Sixth, the profits earned or losses incurred on account of changes in capital assets as a result

of fluctuations in market prices are not included in the GNP if they are not responsible for

current production or economic activity.

For example, if the price of a house or a piece of land increases due to inflation, the profit

earned by selling it will not be a part of GNP. But if, during the current year, a portion of a

house is constructed anew, the increase in the value of the house (after subtracting the cost of

the newly constructed portion) will be included in the GNP. Similarly, variations in the value

of assets, that can be ascertained beforehand and are insured against flood or fire, are not

included in the GNP.

Last, the income earned through illegal activities is not included in the GNP. Although the

goods sold in the black market are priced and fulfill the needs of the people, but as they are

not useful from the social point of view, the income received from their sale and purchase is

always excluded from the GNP.

There are two main reasons for this. One, it is not known whether these things were produced

during the current year or the preceding years. Two, many of these goods are foreign made

and smuggled and hence not included in the GNP.

Three Approaches to GNP:

After having studied the fundamental constituents of GNP, it is essential to know how it is

estimated. Three approaches are employed for this purpose. One, the income method to GNP;

two, the expenditure method to GNP and three, the value added method to GNP. Since gross

income equals gross expenditure, GNP estimated by all these methods would be the same

with appropriate adjustments.

1. Income Method to GNP:

The income method to GNP consists of the remuneration paid in terms of money to the

factors of production annually in a country.

 25

Thus GNP is the sum total of the following items:

(i) Wages and salaries:

Under this head are included all forms of wages and salaries earned through productive

activities by workers and entrepreneurs. It includes all sums received or deposited during a

year by way of all types of contributions like overtime, commission, provident fund,

insurance, etc.

(ii) Rents:

Total rent includes the rents of land, shop, house, factory, etc. and the estimated rents of all

such assets as are used by the owners themselves.

(iii) Interest:

Under interest comes the income by way of interest received by the individual of a country

from different sources. To this is added, the estimated interest on that private capital which is

invested and not borrowed by the businessman in his personal business. But the interest

received on governmental loans has to be excluded, because it is a mere transfer of national

income.

(iv) Dividends:

Dividends earned by the shareholders from companies are included in the GNP.

(v) Undistributed corporate profits:

Profits which are not distributed by companies and are retained by them are included in the

GNP.

(vi) Mixed incomes:

These include profits of unincorporated business, self-employed persons and partnerships.

They form part of GNP.

(vii) Direct taxes:

Taxes levied on individuals, corporations and other businesses are included in the GNP.
 26

(viii) Indirect taxes:

The government levies a number of indirect taxes, like excise duties and sales tax.

These taxes are included in the price of commodities. But revenue from these goes to the

government treasury and not to the factors of production. Therefore, the income due to such

taxes is added to the GNP.

(ix) Depreciation:

Every corporation makes allowance for expenditure on wearing out and depreciation of

machines, plants and other capital equipment. Since this sum also is not a part of the income

received by the factors of production, it is, therefore, also included in the GNP.

(x) Net income earned from abroad:

This is the difference between the value of exports of goods and services and the value of

imports of goods and services. If this difference is positive, it is added to the GNP and if it is

negative, it is deducted from the GNP.

Thus GNP according to the Income Method = Wages and Salaries + Rents + Interest +

Dividends + Undistributed Corporate Profits + Mixed Income + Direct Taxes + Indirect

Taxes + Depreciation + Net Income from abroad.

2. Expenditure Method to GNP:

From the expenditure view point, GNP is the sum total of expenditure incurred on goods and

services during one year in a country.

It includes the following items:

(i) Private consumption expenditure:

It includes all types of expenditure on personal consumption by the individuals of a country.

It comprises expenses on durable goods like watch, bicycle, radio, etc., expenditure on single-

used consumers’ goods like milk, bread, ghee, clothes, etc., as also the expenditure incurred
 27

on services of all kinds like fees for school, doctor, lawyer and transport. All these are taken

as final goods.

(ii) Gross domestic private investment:

Under this comes the expenditure incurred by private enterprise on new investment and on

replacement of old capital. It includes expenditure on house construction, factory- buildings,

and all types of machinery, plants and capital equipment.

In particular, the increase or decrease in inventory is added to or subtracted from it. The

inventory includes produced but unsold manufactured and semi-manufactured goods during

the year and the stocks of raw materials, which have to be accounted for in GNP. It does not

take into account the financial exchange of shares and stocks because their sale and purchase

is not real investment. But depreciation is added.

(iii) Net foreign investment:

It means the difference between exports and imports or export surplus. Every country exports

to or imports from certain foreign countries. The imported goods are not produced within the

country and hence cannot be included in national income, but the exported goods are

manufactured within the country. Therefore, the difference of value between exports (X) and

imports (M), whether positive or negative, is included in the GNP.

(iv) Government expenditure on goods and services:

The expenditure incurred by the government on goods and services is a part of the GNP.

Central, state or local governments spend a lot on their employees, police and army. To run

the offices, the governments have also to spend on contingencies which include paper, pen,

pencil and various types of stationery, cloth, furniture, cars, etc.

It also includes the expenditure on government enterprises. But expenditure on transfer

payments is not added, because these payments are not made in exchange for goods and

services produced during the current year.

 28

Thus GNP according to the Expenditure Method=Private Consumption Expenditure (C) +

Gross Domestic Private Investment (I) + Net Foreign Investment (X-M) + Government

Expenditure on Goods and Services (G) = C+ I + (X-M) + G.

As already pointed out above, GNP estimated by either the income or the expenditure method

would work out to be the same, if all the items are correctly calculated.

3. Value Added Method to GNP:

Another method of measuring GNP is by value added. In calculating GNP, the money value

of final goods and services produced at current prices during a year is taken into account.

This is one of the ways to avoid double counting. But it is difficult to distinguish properly

between a final product and an intermediate product.

For instance, raw materials, semi-finished products, fuels and services, etc. are sold as inputs

by one industry to the other. They may be final goods for one industry and intermediate for

others. So, to avoid duplication, the value of intermediate products used in manufacturing

final products must be subtracted from the value of total output of each industry in the

economy.

Thus, the difference between the value of material outputs and inputs at each stage of

production is called the value added. If all such differences are added up for all industries in

the economy, we arrive at the GNP by value added. GNP by value added = Gross value

added + net income from abroad. Its calculation is shown in Tables 1, 2 and 3.

Table 1 is constructed on the supposition that the entire economy for purposes of total

production consists of three sectors. They are agriculture, manufacturing, and others,

consisting of the tertiary sector.

Out of the value of total output of each sector is deducted the value of its intermediate

purchases (or primary inputs) to arrive at the value added for the entire economy. Thus the

value of total output of the entire economy as per Table 1, is Rs. 155 crores and the value of
 29

its primary inputs comes to Rs. 80 crores. Thus the GDP by value added is Rs. 75 crores (Rs.

155 minus Rs. 80 crores).

The total value added equals the value of gross domestic product of the economy. Out of this

value added, the major portion goes in the form wages and salaries, rent, interest and profits,

a small portion goes to the government as indirect taxes and the remaining amount is meant

for depreciation. This is shown in Table 3.

Thus we find that the total gross value added of an economy equals the value of its gross

domestic product. If depreciation is deducted from the gross value added, we have net value

added which comes to Rs. 67 crores (Rs. 75 minus Rs. 8 crores).

This is nothing but net domestic product at market prices. Again, if indirect taxes (Rs. 7

crores) are deducted from the net domestic product of Rs. 67 crores, we get Rs. 60 crores as

the net value added at factor cost which is equivalent to net domestic product at factor cost.

This is illustrated in Table 2.

 30

Net value added at factor cost is equal to the net domestic product at factor cost, as given by

the total of items 1 to 4 of Table 2 (Rs. 45+3+4+8 crores=Rs. 60 crores). By adding indirect

taxes (Rs 7 crores) and depreciation (Rs 8 crores), we get gross value added or GDP which

comes to Rs 75 crores.

If we add net income received from abroad to the gross value added, this gives -us, gross

national income. Suppose net income from abroad is Rs. 5 crores. Then the gross national

income is Rs. 80 crores (Rs. 75 crores + Rs. 5 crores) as shown in Table 3.

It’s Importance:

The value added method for measuring national income is more realistic than the product and

income methods because it avoids the problem of double counting by excluding the value of

intermediate products. Thus this method establishes the importance of intermediate products

in the national economy. Second, by studying the national income accounts relating to value

added, the contribution of each production sector to the value of the GNP can be found out.
 31

For instance, it can tell us whether agriculture is contributing more or the share of

manufacturing is falling, or of the tertiary sector is increasing in the current year as compared

to some previous years. Third, this method is highly useful because “it provides a means of

checking the GNP estimates obtained by summing the various types of commodity

purchases.”

It’s Difficulties:

However, difficulties arise in the calculation of value added in the case of certain public

services like police, military, health, education, etc. which cannot be estimated accurately in

money terms. Similarly, it is difficult to estimate the contribution made to value added by

profits earned on irrigation and power projects.

(G) GNP at Market Prices:

When we multiply the total output produced in one year by their market prices prevalent

during that year in a country, we get the Gross National Product at market prices. Thus GNP

at market prices means the gross value of final goods and services produced annually in a

country plus net income from abroad. It includes the gross value of output of all items from

(1) to (4) mentioned under GNP. GNP at Market Prices = GDP at Market Prices + Net

Income from Abroad.

(H) GNP at Factor Cost:

GNP at factor cost is the sum of the money value of the income produced by and accruing to

the various factors of production in one year in a country. It includes all items mentioned

above under income method to GNP less indirect taxes.

GNP at market prices always includes indirect taxes levied by the government on goods

which raise their prices. But GNP at factor cost is the income which the factors of production

receive in return for their services alone. It is the cost of production.

Thus GNP at market prices is always higher than GNP at factor cost. Therefore, in order to

arrive at GNP at factor cost, we deduct indirect taxes from GNP at market prices. Again, it
 32

often happens that the cost of production of a commodity to the producer is higher than a

price of a similar commodity in the market.

In order to protect such producers, the government helps them by granting monetary help in

the form of a subsidy equal to the difference between the market price and the cost of

production of the commodity. As a result, the price of the commodity to the producer is

reduced and equals the market price of similar commodity.

For example if the market price of rice is Rs. 3 per kg but it costs the producers in certain

areas Rs. 3.50. The government gives a subsidy of 50 paisa per kg to them in order to meet

their cost of production. Thus in order to arrive at GNP at factor cost, subsidies are added to

GNP at market prices.

GNP at Factor Cost = GNP at Market Prices – Indirect Taxes + Subsidies.

(I) Net National Product (NNP):

NNP includes the value of total output of consumption goods and investment goods. But the

process of production uses up a certain amount of fixed capital. Some fixed equipment wears

out, its other components are damaged or destroyed, and still others are rendered obsolete

through technological changes.

All this process is termed depreciation or capital consumption allowance. In order to arrive at

NNP, we deduct depreciation from GNP. The word ‘net’ refers to the exclusion of that part of

total output which represents depreciation. So NNP = GNP—Depreciation.

(J) NNP at Market Prices:

Net National Product at market prices is the net value of final goods and services evaluated at

market prices in the course of one year in a country. If we deduct depreciation from GNP at

market prices, we get NNP at market prices. So NNP at Market Prices = GNP at Market

Prices—Depreciation.

(K) NNP at Factor Cost:

 33

Net National Product at factor cost is the net output evaluated at factor prices. It includes

income earned by factors of production through participation in the production process such

as wages and salaries, rents, profits, etc. It is also called National Income. This measure

differs from NNP at market prices in that indirect taxes are deducted and subsidies are added

to NNP at market prices in order to arrive at NNP at factor cost. Thus

NNP at Factor Cost = NNP at Market Prices – Indirect taxes+ Subsidies

= GNP at Market Prices – Depreciation – Indirect taxes + Subsidies.

= National Income.

Normally, NNP at market prices is higher than NNP at factor cost because indirect taxes

exceed government subsidies. However, NNP at market prices can be less than NNP at factor

cost when government subsidies exceed indirect taxes.

(L) Domestic Income:

Income generated (or earned) by factors of production within the country from its own

resources is called domestic income or domestic product.

Domestic income includes:

(i) Wages and salaries, (ii) rents, including imputed house rents, (iii) interest, (iv) dividends,

(v) undistributed corporate profits, including surpluses of public undertakings, (vi) mixed

incomes consisting of profits of unincorporated firms, self- employed persons, partnerships,

etc., and (vii) direct taxes.

Since domestic income does not include income earned from abroad, it can also be shown as:

Domestic Income = National Income-Net income earned from abroad. Thus the difference

between domestic income f and national income is the net income earned from abroad. If we

add net income from abroad to domestic income, we get national income, i.e., National

Income = Domestic Income + Net income earned from abroad.

 34

But the net national income earned from abroad may be positive or negative. If exports

exceed import, net income earned from abroad is positive. In this case, national income is

greater than domestic income. On the other hand, when imports exceed exports, net income

earned from abroad is negative and domestic income is greater than national income.

(M) Private Income:

Private income is income obtained by private individuals from any source, productive or

otherwise, and the retained income of corporations. It can be arrived at from NNP at Factor

Cost by making certain additions and deductions.

The additions include transfer payments such as pensions, unemployment allowances,

sickness and other social security benefits, gifts and remittances from abroad, windfall gains

from lotteries or from horse racing, and interest on public debt. The deductions include

income from government departments as well as surpluses from public undertakings, and

employees’ contribution to social security schemes like provident funds, life insurance, etc.

Thus Private Income = National Income (or NNP at Factor Cost) + Transfer Payments +

Interest on Public Debt — Social Security — Profits and Surpluses of Public Undertakings.

(N) Personal Income:

Personal income is the total income received by the individuals of a country from all sources

before payment of direct taxes in one year. Personal income is never equal to the national

income, because the former includes the transfer payments whereas they are not included in

national income.

Personal income is derived from national income by deducting undistributed corporate

profits, profit taxes, and employees’ contributions to social security schemes. These three

components are excluded from national income because they do reach individuals.

But business and government transfer payments, and transfer payments from abroad in the

form of gifts and remittances, windfall gains, and interest on public debt which are a source
 35

of income for individuals are added to national income. Thus Personal Income = National

Income – Undistributed Corporate Profits – Profit Taxes – Social Security Contribution +

Transfer Payments + Interest on Public Debt.

Personal income differs from private income in that it is less than the latter because it

excludes undistributed corporate profits.

Thus Personal Income = Private Income – Undistributed Corporate Profits – Profit Taxes.

(O) Disposable Income:

Disposable income or personal disposable income means the actual income which can be

spent on consumption by individuals and families. The whole of the personal income cannot

be spent on consumption, because it is the income that accrues before direct taxes have

actually been paid. Therefore, in order to obtain disposable income, direct taxes are deducted

from personal income. Thus Disposable Income=Personal Income – Direct Taxes.

But the whole of disposable income is not spent on consumption and a part of it is saved.

Therefore, disposable income is divided into consumption expenditure and savings. Thus

Disposable Income = Consumption Expenditure + Savings.

If disposable income is to be deduced from national income, we deduct indirect taxes plus

subsidies, direct taxes on personal and on business, social security payments, undistributed

corporate profits or business savings from it and add transfer payments and net income from

abroad to it.

Thus Disposable Income = National Income – Business Savings – Indirect Taxes + Subsidies

– Direct Taxes on Persons – Direct Taxes on Business – Social Security Payments + Transfer

Payments + Net Income from abroad.

(P) Real Income:

 36

Real income is national income expressed in terms of a general level of prices of a particular

year taken as base. National income is the value of goods and services produced as expressed

in terms of money at current prices. But it does not indicate the real state of the economy.

It is possible that the net national product of goods and services this year might have been

less than that of the last year, but owing to an increase in prices, NNP might be higher this

year. On the contrary, it is also possible that NNP might have increased but the price level

might have fallen, as a result national income would appear to be less than that of the last

year. In both the situations, the national income does not depict the real state of the country.

To rectify such a mistake, the concept of real income has been evolved.

In order to find out the real income of a country, a particular year is taken as the base year

when the general price level is neither too high nor too low and the price level for that year is

assumed to be 100. Now the general level of prices of the given year for which the national

income (real) is to be determined is assessed in accordance with the prices of the base year.

For this purpose the following formula is employed.

Real NNP = NNP for the Current Year x Base Year Index (=100) / Current Year Index

Suppose 1990-91 is the base year and the national income for 1999-2000 is Rs. 20,000 crores

and the index number for this year is 250. Hence, Real National Income for 1999-2000 will

be = 20000 x 100/250 = Rs. 8000 crores. This is also known as national income at constant

prices.

(Q) Per Capita Income:

The average income of the people of a country in a particular year is called Per Capita

Income for that year. This concept also refers to the measurement of income at current prices

and at constant prices. For instance, in order to find out the per capita income for 2001, at

current prices, the national income of a country is divided by the population of the country in

that year.
 37

Similarly, for the purpose of arriving at the Real Per Capita Income, this very formula is

used.

This concept enables us to know the average income and the standard of living of the people.

But it is not very reliable, because in every country due to unequal distribution of national

income, a major portion of it goes to the richer sections of the society and thus income

received by the common man is lower than the per capita income.

3. Methods of Measuring National Income:

There are four methods of measuring national income. Which method is to be used depends

on the availability of data in a country and the purpose in hand.

(1) Product Method:

According to this method, the total value of final goods and services produced in a country

during a year is calculated at market prices. To find out the GNP, the data of all productive

activities, such as agricultural products, wood received from forests, minerals received from

mines, commodities produced by industries, the contributions to production made by

transport, communications, insurance companies, lawyers, doctors, teachers, etc. are collected

and assessed at market prices. Only the final goods and services are included and the

intermediary goods and services are left out.

(2) Income Method:

According to this method, the net income payments received by all citizens of a country in a

particular year are added up, i.e., net incomes that accrue to all factors of production by way

of net rents, net wages, net interest and net profits are all added together but incomes received

in the form of transfer payments are not included in it. The data pertaining to income are
 38

obtained from different sources, for instance, from income tax department in respect of high

income groups and in case of workers from their wage bills.

(3) Expenditure Method:

According to this method, the total expenditure incurred by the society in a particular year is

added together and includes personal consumption expenditure, net domestic investment,

government expenditure on goods and services, and net foreign investment. This concept is

based on the assumption that national income equals national expenditure.

(4) Value Added Method:

Another method of measuring national income is the value added by industries. The

difference between the value of material outputs and inputs at each stage of production is the

value added. If all such differences are added up for all industries in the economy, we arrive

at the gross domestic product.

4. Difficulties or Limitations in Measuring National Income:

There are many conceptual and statistical problems involved in measuring national income

by the income method, product method, and expenditure method.

We discuss them separately in the light of the three methods:

(A) Problems in Income Method:

The following problems arise in the computation of National Income by income method:

1. Owner-occupied Houses:

A person who rents a house to another earns rental income, but if he occupies the house

himself, will the services of the house-owner be included in national income. The services of

the owner-occupied house are included in national income as if the owner sells to himself as a

tenant its services.

For the purpose of national income accounts, the amount of imputed rent is estimated as the

sum for which the owner-occupied house could have been rented. The imputed net rent is
 39

calculated as that portion of the amount that would have accrued to the house-owner after

deducting all expenses.

2. Self-employed Persons:

Another problem arises with regard to the income of self-employed persons. In their case, it

is very difficult to find out the different inputs provided by the owner himself. He might be

contributing his capital, land, labour and his abilities in the business. But it is not possible to

estimate the value of each factor input to production. So he gets a mixed income consisting of

interest, rent, wage and profits for his factor services. This is included in national income.

3. Goods meant for Self-consumption:

In under-developed countries like India, farmers keep a large portion of food and other goods

produced on the farm for self-consumption. The problem is whether that part of the produce

which is not sold in the market can be included in national income or not. If the farmer were

to sell his entire produce in the market, he will have to buy what he needs for self-

consumption out of his money income. If, instead he keeps some produce for his self-

consumption, it has money value which must be included in national income.

4. Wages and Salaries paid in Kind:

Another problem arises with regard to wages and salaries paid in kind to the employees in the

form of free food, lodging, dress and other amenities. Payments in kind by employers are

included in national income. This is because the employees would have received money

income equal to the value of free food, lodging, etc. from the employer and spent the same in

paying for food, lodging, etc.

(B) Problems in Product Method:

The following problems arise in the computation of national income by product

method:

1. Services of Housewives:
 40

The estimation of the unpaid services of the housewife in the national income presents a

serious difficulty. A housewife renders a number of useful services like preparation of meals,

serving, tailoring, mending, washing, cleaning, bringing up children, etc.

She is not paid for them and her services are not including in national income. Such services

performed by paid servants are included in national income. The national income is,

therefore, underestimated by excluding the services of a housewife.

The reason for the exclusion of her services from national income is that the love and

affection of a housewife in performing her domestic work cannot be measured in monetary

terms. That is why when the owner of a firm marries his lady secretary, her services are not

included in national income when she stops working as a secretary and becomes a housewife.

When a teacher teaches his own children, his work is also not included in national income.

Similarly, there are a number of goods and services which are difficult to be assessed in

money terms for the reason stated above, such as painting, singing, dancing, etc. as hobbies.

2. Intermediate and Final Goods:

The greatest difficulty in estimating national income by product method is the failure to

distinguish properly between intermediate and final goods. There is always the possibility of

including a good or service more than once, whereas only final goods are included in national

income estimates. This leads to the problem of double counting which leads to the

overestimation of national income.

3. Second-hand Goods and Assets:

Another problem arises with regard to the sale and purchase of second-hand goods and assets.

We find that old scooters, cars, houses, machinery, etc. are transacted daily in the country.

But they are not included in national income because they were counted in the national

product in the year they were manufactured.

 41

If they are included every time they are bought and sold, national income would increase

many times. Similarly, the sale and purchase of old stocks, shares, and bonds of companies

are not included in national income because they were included in national income when the

companies were started for the first time. Now they are simply financial transactions and

represent claims.

But the commission or fees charged by the brokers in the repurchase and resale of old shares,

bonds, houses, cars or scooters, etc. are included in national income. For these are the

payments they receive for their productive services during the year.

4. Illegal Activities:

Income earned through illegal activities like gambling, smuggling, illicit extraction of wine,

etc. is not included in national income. Such activities have value and satisfy the wants of the

people but they are not considered productive from the point of view of society. But in

countries like Nepal and Monaco where gambling is legalised, it is included in national

income. Similarly, horse-racing is a legal activity in England and is included in national

income.

5. Consumers’ Service:

There are a number of persons in society who render services to consumers but they do not

produce anything tangible. They are the actors, dancers, doctors, singers, teachers, musicians,

lawyers, barbers, etc. The problem arises about the inclusion of their services in national

income since they do not produce tangible commodities. But as they satisfy human wants and

receive payments for their services, their services are included as final goods in estimating

national income.

6. Capital Gains:

The problem also arises with regard to capital gains. Capital gains arise when a capital asset

such as a house, some other property, stocks or shares, etc. is sold at higher price than was

paid for it at the time of purchase. Capital gains are excluded from national income because
 42

these do not arise from current economic activities. Similarly, capital losses are not taken into

account while estimating national income.

7. Inventory Changes:

All inventory changes (or changes in stocks) whether positive or negative are included in

national income. The procedure is to take changes in physical units of inventories for the year

valued at average current prices paid for them.

The value of changes in inventories may be positive or negative which is added or subtracted

from the current production of the firm. Remember, it is the change in inventories and not

total inventories for the year that are taken into account in national income estimates.

8. Depreciation:

Depreciation is deducted from GNP in order to arrive at NNP. Thus depreciation lowers the

national income. But the problem is of estimating the current depreciated value of, say, a

machine, whose expected life is supposed to be thirty years. Firms calculate the depreciation

value on the original cost of machines for their expected life. This does not solve the problem

because the prices of machines change almost every year.

9. Price Changes:

National income by product method is measured by the value of final goods and services at

current market prices. But prices do not remain stable. They rise or fall. When the price level

rises, the national income also rises, though the national production might have fallen.

On the contrary, with the fall in the price level, the national income also falls, though the

national production might have increased. So price changes do not adequately measure

national income. To solve this problem, economists calculate the real national income at a

constant price level by the consumer price index.

(C) Problems in Expenditure Method:

 43

The following problems arise in the calculation of national income by expenditure

method:

(1) Government Services:

In calculating national income by, expenditure method, the problem of estimating

government services arises. Government provides a number of services, such as police and

military services, administrative and legal services. Should expenditure on government

services be included in national income?

If they are final goods, then only they would be included in national income. On the other

hand, if they are used as intermediate goods, meant for further production, they would not be

included in national income. There are many divergent views on this issue.

One view is that if police, military, legal and administrative services protect the lives,

property and liberty of the people, they are treated as final goods and hence form part of

national income. If they help in the smooth functioning of the production process by

maintaining peace and security, then they are like intermediate goods that do not enter into

national income.

In reality, it is not possible to make a clear demarcation as to which service protects the

people and which protects the productive process. Therefore, all such services are regarded as

final goods and are included in national income.

(2) Transfer Payments:

There arises the problem of including transfer payments in national income. Government

makes payments in the form of pensions, unemployment allowance, subsidies, interest on

national debt, etc. These are government expenditures but they are not included in national

income because they are paid without adding anything to the production process during the

current year.

For instance, pensions and unemployment allowances are paid to individuals by the

government without doing any productive work during the year. Subsidies tend to lower the
 44

market price of the commodities. Interest on national or public debt is also considered a

transfer payment because it is paid by the government to individuals and firms on their past

savings without any productive work.

(3) Durable-use Consumers’ Goods:

Durable-use consumers’ goods also pose a problem. Such durable-use consumers’ goods as

scooters, cars, fans, TVs, furniture’s, etc. are bought in one year but they are used for a

number of years. Should they be included under investment expenditure or consumption

expenditure in national income estimates? The expenditure on them is regarded as final

consumption expenditure because it is not possible to measure their used up value for the

subsequent years.

But there is one exception. The expenditure on a new house is regarded as investment

expenditure and not consumption expenditure. This is because the rental income or the

imputed rent which the house-owner gets is for making investment on the new house.

However, expenditure on a car by a household is consumption expenditure. But if he spends

the amount for using it as a taxi, it is investment expenditure.

(4) Public Expenditure:

Government spends on police, military, administrative and legal services, parks, street

lighting, irrigation, museums, education, public health, roads, canals, buildings, etc. The

problem is to find out which expenditure is consumption expenditure and which investment

expenditure is.

Expenses on education, museums, public health, police, parks, street lighting, civil and

judicial administration are consumption expenditure. Expenses on roads, canals, buildings,

etc. are investment expenditure. But expenses on defence equipment are treated as

consumption expenditure because they are consumed during a war as they are destroyed or

become obsolete. However, all such expenses including the salaries of armed personnel are

included in national income.

 45

5. Importance of National Income Analysis:

The national income data have the following importance:

1. For the Economy:

National income data are of great importance for the economy of a country. These days the

national income data are regarded as accounts of the economy, which are known as social

accounts. These refer to net national income and net national expenditure, which ultimately

equal each other.

Social accounts tell us how the aggregates of a nation’s income, output and product result

from the income of different individuals, products of industries and transactions of

international trade. Their main constituents are inter-related and each particular account can

be used to verify the correctness of any other account.

2. National Policies:

National income data form the basis of national policies such as employment policy, because

these figures enable us to know the direction in which the industrial output, investment and

savings, etc. change, and proper measures can be adopted to bring the economy to the right

path.

3. Economic Planning:

In the present age of planning, the national data are of great importance. For economic

planning, it is essential that the data pertaining to a country’s gross income, output, saving

and consumption from different sources should be available. Without these, planning is not

possible.

4. Economic Models:

The economists propound short-run as well as long-run economic models or long-run

investment models in which the national income data are very widely used.
 46

5. Research:

The national income data are also made use of by the research scholars of economics. They

make use of the various data of the country’s input, output, income, saving, consumption,

investment, employment, etc., which are obtained from social accounts.

6. Per Capita Income:

National income data are significant for a country’s per capita income which reflects the

economic welfare of the country. The higher the per capita income, the higher the economic

welfare of the country.

7. Distribution of Income:

National income statistics enable us to know about the distribution of income in the country.

From the data pertaining to wages, rent, interest and profits, we learn of the disparities in the

incomes of different sections of the society. Similarly, the regional distribution of income is

revealed.

It is only on the basis of these that the government can adopt measures to remove the

inequalities in income distribution and to restore regional equilibrium. With a view to

removing these personal and regional disequibria, the decisions to levy more taxes and

increase public expenditure also rest on national income statistics.

6. Inter-Relationship among different concept of National Income

The inter-relationship among the various concept of national income can be shown in the

form of equations as under:

 
 47

The Circular Flow of Income and Expenditure

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Let us learn about the Circular Flow of Income and Expenditure in a Two Sector
Economy.
The national income and national product accounts of a country describe the economic
performance or production performance of a country .
 48

Various measures of the nation’s income and product exist:

ADVERTISEMENTS:

The most frequently cited summary measures of an economy’s performance is the gross
national product (GNP) or gross domestic product (GDP). However, there is a subtle
distinction between GNP and GDP since both move closely together. Anyway, the distinction
between the two will be presented in due time.

The national product is the value of final goods and services produced in a country. Since all
the value produced must belong to someone in the form of a claim on the value, national
product is equal to national income. Each transaction in an economy involves a buyer and a
seller. Households spend money for buying goods and services produced.

Thus, from the buyer’s side comes the flow of money demand. In other words, we have
expenditure- side transaction. On the seller’s side, money payments go to factor owners in the
form of rent, wages, etc. Firms spend money for buying input services. Thus, we have
income- side transaction from the seller’s side. These two are obverse and reverse of the same
coin. This is called circular flow of income and expenditure.

Graphically, we can present the circular flow of income.

ADVERTISEMENTS:

We are assuming that we are living in a market-oriented economy or capitalistic

economy where there are two decision-makers:
Firms and households.

Firms make production decision. Households are consuming units which absorb output
produced in the business firms. Again, firms coordinate and employ different factor units
which are owned by households.

In Fig. 8.1, goods and services flow from firms to households via the product market in return
for the money payment for these goods and services by firms.

ADVERTISEMENTS:

Arrowhead indicates such goods flow and money flow between firms and households. It is
clear that the flow of monetary payment on goods and services by buyers must be identical to
the money value of all goods and services that firms produce and sell to the households.
 49

But wherefrom do the households get money? The diagram answers this question.
Households supply factor inputs to firms via the factor market. In return, households receive
money from firms in the form of rent, wages, etc. These income payments to households on
hiring input services must be identical to the firms’ income.

This is the essence of the circular flow of income in a two-sector economy where there is no
governmental activity and the economy is a closed one.

Adding these, we have:

Y=C+I

Where, Y denotes national incomes, C private consumption spending and I private

investment spending.

In a three-sector (closed) economy, the government intervenes. It spends not only for the
benefits of the general people and firms but also imposes taxes on them to finance its
spending. If we add government activities (levying of taxes, T, and incurring expenditures,
G), we have

Y=C+I+G

ADVERTISEMENTS:

The relationship between households, firms and the government have been presented in
a circular way in Fig. 8.2:
 50

A four-sector economy is called an open economy in the sense that the country gets money
by sending its goods outside, i.e., exports (X), and spends money by buying foreign-made
goods and services, i.e., imports (M).

In other words, in an open economy, there occurs a trading relationship between nations. The
circular flow model in a four-sector open economy has been shown in Fig. 8.3. Adding (X –
M) in the above equation, we get

ADVERTISEMENTS:

Y = C + I + G + (X – M)

The only difference in the circular flow of income between a closed economy and an open
economy is that, in a four-sector economy, households purchase foreign-made goods and
services (i.e., imports). Likewise, people of other countries purchase goods and services not
produced domestically (i.e., exports).
 51

Imports constitute leakage from the circular flow while exports constitute injection in the
circular flow. For simplicity’s sake, we have not shown in the diagram that firms and
governments also sell export goods and purchase import goods.

ADVERTISEMENTS:

Note that (I + G + X) constitute injections into the circular flow of income while(S + T + M)
constitute withdrawals or leakages from the circular flow of income. Injections increase
national income and leakages decrease national income.

The national product or national income measures the overall economic performance of a
nation. To measure the national product, we add up the value of all final goods and services
produced in a country in a year. Thus, we focus on firms or sellers which receive payment for
the production. This is the product method of calculating national income.
Circular Flow of Income: 2 Sector, 3 Sector and 4 Sector Economy

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Let us make in-depth study of the circular flow of income in two sector, three sector and
four sector economy.
Circular Income Flow in a Two Sector Economy:
National Income Accounting : Meaning, Functions and Main Uses

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Read this article to learn about the national income accounting and its meaning,
functions and main uses!
National Income Accounting facilitates the task of measurement as it provides a set of
procedures and techniques for measurement of income and output at aggregate level.

We study national income accounting for two reasons because such accounts (i) provide the
formal structure for our macro theory model and (ii) enable us to learn a few hallmark
numbers which help characterise the economy.

(a) Meaning:
 52

ADVERTISEMENTS:

National Income Accounting is a method of preparing and presenting national income

accounts based on the principle of double entry system of business accounting.
Macroeconomics deals with the study of aggregates covering the entire economy A
framework of measurement procedures is required to find these aggregates. National income
accounting facilitates the measurement of macro aggregates.

According to D.C. Colander, “National income accounting is a set of rules and definitions for
measuring economic activity in the aggregate economy.” It tries to summarise the
performance of an economy by measuring national income aggregates in a year. It provides
the standards by which economic activity of a country could be assessed.

It is on the basis of this appraisal that a government forms its policies and programmes to
maximise material welfare of the people. And this is the basic purpose of national income
accounting. Structure of the macro economy is given by the circular flow of income and
output. National income accounting has its foundation in circular flow model.

(b) Functions:
Basic functions of national income accounting are mainly two:
ADVERTISEMENTS:

(i) To identify specific economic achievements of a country and

(ii) To provide an objective basis of evaluation and review of policies under implementation.

The data so arrived at enables us to understand, analyse and interpret the working of an
economy. That is why the subject of macroeconomics should begin with a study of national
income accounting.

(c) Main Uses of National Income Accounting:

These are as under:
ADVERTISEMENTS:

(i) It indicates performance of the economy signifying economy’s strength and failures.

(ii) It helps to find out structural changes in the economy For instance, in India, proportional
share of primary (agricultural) sector in national income is declining whereas those of
secondary (industrial) sector and tertiary (services) sector are rising.
 53

(iii) It reflects how national income is shared among various factors of production. In this
context, it is especially helpful to trade unions in making rational analysis of remuneration
that the labour is getting.

(iv) It helps in making comparison among nations in respect of national income and per
capita income which lead us to make suitable changes in plans and approaches to achieve
rapid economic development.

(v) National income statistical data reflect the specific contribution of individual sectors and
their growth over time.

(vi) It is helpful to UNO which formulates welfare plans for different countries, especially for
underdeveloped and developing countries.

(vii) It has several uses for economic policy and research.

Simply put, national income data, in a way, is manifestation of material results of human
activity in an economy. National income accounting demands an understanding of the
structure of the macro economy which is exposed through a Circular Flow of Income and
Product.

Real flows of resources, goods and services have been shown in Fig. 6.1. In the upper loop of
this figure, the resources such as land, capital and entrepreneurial ability flow from
households to business firms as indicated by the arrow mark.

In opposite direction to this, money flows from business firms to the households as factor
payments such as wages, rent, interest and profits.
 54

In the lower part of the

figure, money flows from households to firms as consumption expenditure made by the
households on the goods and services produced by the firms, while the flow of goods and
services is in opposite direction from business firms to households.
Thus we see that money flows from business firms to households as factor payments and then
it flows from households to firms. Thus there is, in fact, a circular flow of money or income.
This circular flow of money will continue indefinitely week by week and year by year. This
is how the economy functions. It may, however, be pointed out that this flow of money
income will not always remain the same in volume.

In other words, the flow of money income will not always continue at a constant level. In
year of depression, the circular flow of money income will contract, i.e., will become lesser
in volume, and in years of prosperity it will expand, i.e., will become greater in volume.

This is so because the flow of money is a measure of national income and will, therefore,
change with changes in the national income. In year of depression, when national income is
low, the volume of the flow of money will be small and in years of prosperity when the level
of national income is quite high, the flow of money will be large.

In order to make our analysis simple and to explain the central issues involved, we take many
assumptions. In the first place, we assume that neither the households save from their
incomes, nor the firms save from their profits. We further assume that the government does
not play any part in the national economy.

ADVERTISEMENTS:
 55

In other words, the government does not receive any money from the people by way of taxes,
nor does the government spend any money on the goods and services produced by the firms
or on the resources and services supplied by the households. Thirdly, we assume that the
economy neither imports goods and services, nor exports anything. In other words, in our
above analysis we have not taken into account the role of foreign trade. In fact we have
explained above the flow of money that occurs in the functioning of a closed economy with
no savings and no role of government.

Circular Income Flow with Saving and Investment:

In our above analysis of the circular flow of income we have assumed that all income which
the households receive, they spend it on consumer goods and services. A result, circular flow
of money speeding and income remains undiminished. We will now explain if households
save a part of their income, how their savings will affect money flows in the economy.

When households save, their expenditure on goods and services will decline to that extent
and as a result money flow to the business firms will contract. With reduced money receipts,
firms will hire fewer workers (or lay off some workers) or reduce the factor payments they
make to the suppliers of factors such as workers.

This will lead to the fall in total incomes of the households. Thus, savings reduce the flow of
money expenditure to the business firms and will cause a fall in economy’s total income.
Economists therefore call savings a leakage from the money expenditure flow.

ADVERTISEMENTS:

But savings by households need not lead to reduced aggregate spending and income if they
find their way back into flow of expenditure. In free market economies there exists a set of
institutions such as banks, insurance companies, financial houses, stock markets where
households deposit their savings. All these institutions together are called financial
institutions or financial market. We assume that all the savings of households come in the
financial market. We further assume that there are no inter-households borrowings.

It is business firms who borrow from the financial market for investment in capital goods
such as machines, factories, tools and instruments, trucks. Firms spend on investment in order
to expand their productive capacity in future.

Thus, through investment expenditure by borrowing the savings of the households deposited
in financial market, are again brought into the expenditure stream and as a result total flow of
spending does not decrease. Circular money flow with saving and investment is illustrated in
Fig. 6.2 where in the middle part a box representing financial market is drawn. Money flow
 56

of savings is shown from the households towards the financial market. Then flow of
investment expenditure is shown as borrowing by business firms from the financial market.

Condition for the Constancy of Circular Income Flow:

Now the question arises what is the condition for the flow of money income to continue at a
steady level so that it makes possible the production and subsequent flow of a given volume
of goods and services at constant prices. To explain this we have to introduce saving and
investment in the analysis of circular flow of income.

Saving a part of income means it is not spent on consumer goods and services. In other
words, saving is withdrawal of some money from the income flow. On the other hand,
investment means some money is spent on buying new capital goods to expand production
capacity. In other words, investment is injection of some money in circular flow of income.
For the circular flow of income to continue unabated, the withdrawal of money from the
income stream by way of saving must equal injection of money by way of investment
expenditure. Therefore, planned savings must be equal to planned investment if the constant
money income flow in an economy is to be obtained.

Now, what will happen if planned investment expenditure falls short of the planned savings?
As a result of fall in planned investment expenditure, income, output and employment will
fall and therefore the flow of money will contract.

If the equality between planned savings and planned investment is disturbed by increase in
savings, then the immediate effect will be that the stocks of goods lying in the shelves of the
shops will increase (as some of the goods will not be sold due to the fall in consumption i.e.,
increase in savings). Owing to the deficiency of demand for goods and the accumulation of
stocks, retailers will place small orders with the wholesalers. Consequently, smaller amount
 57

of goods will be produced and therefore fewer capital goods like machinery will be indeed
with the result that fixed investment will tend to fall.

ADVERTISEMENTS:

Thus the ultimate effect of either the fall in planned investment or the increase in planned
savings is the same, namely, the fall in income, output, employment and prices with the result
that the flow of money will contract.

On the other hand, if the equality between planned savings and planned investment is
disturbed by the increase in investment demand, the result will be increase in income, output
and employment. Consequently, the flow of money income will expand.

It is thus clear from the above analysis that the flow of money income will continue at a
constant level only when the condition of equality between planned saving and investment is
satisfied. It was believed by classical economists that financial market provides a mechanism
which coordinates the savings of households and the investment expenditure, by the firms.
Rate of interest, which is the price for the use of savings, is determined by saving and
investment.

If savings exceed investment expenditure, rate of interest falls so that, at a lower rate of
interest, investment increases and both become equal. On the contrary, if investment
expenditure is greater than savings, rate of interest will rise so that at a higher rate of interest
savings increase and become equal to planned investment expenditure.

ADVERTISEMENTS:

However, an eminent British economist J.M. Keynes refuted the above argument that
changes in rate of interest will cause saving and investment to become equal. According to
him, since in a free market capitalist economy, investment is made by business enterprises
and savings are mostly done by households and for different reasons, there is no guarantee
that planned investment will be equal to planned savings and thus fluctuations in income,
output and employment are inevitable.

As a result, circular flow of income does not continue at a steady level in a free-enterprise
capitalist economy unless certain corrective and preventive steps are taken by the government
to maintain stability in the economy.

Saving-Investment Identity in National Income Accounts in a Two Sector Economy:

 58

Despite the fact that people who save are different from the business firms which primarily
invest, in national income accounts savings are identical or always equal to investment in a
simple two sector economy having no roles of Government and foreign trade. This is a basic
identity in national income accounts which needs to be carefully understood.

Of course, in our above analysis of circular flow of income, we explained that planned
investment by business firms can differ from savings by household. But in that analysis we
referred to planned or intended investment and savings which often differ and affect the flow
of national income.

ADVERTISEMENTS:

However, in national income accounts we are concerned with actual saving and actual
investment. It is these actual or realised saving and investment that are identical in national
income accounts. We can prove their identity in the following way.

In a simple economy which has neither government, nor foreign trade, the value of output
produced which we denote by Y is equal to the value of output sold. Since the value of output
sold in a simple two sector economy is equal to the sum of consumption expenditure and
investment expenditure we have y= C+ I where Y = Value of aggregate output, C =
Consumption expenditure and I = Investment expenditure.

A pertinent question which arises here is what happens to the unsold output. The unsold
output leads to the increase in the inventories of goods and in national income accounting
increase in inventories of goods is treated as a part of actual investment. This may be
considered as the firms selling the goods to themselves to add to their inventories. Thus,
gross national product (GNP) produced is used either for consumption or for investment.

Now, look at the gross national product or income in the simple economy from the viewpoint
of its allocation between consumption and saving. Since national income (which is equal to
GNP) can be either consumed or saved,. We have Y Ξ C+ S

ADVERTISEMENTS:

From the identities (i) and (ii) we get

C+ I Ξ Y Ξ C+ S

The left hand side of the identity (iii), namely C + I = Y shows the components of aggregate
demand (that is, aggregate expenditure on goods and services produced) and the right-hand
 59

side of the identity (iii) namely Y = C + S shows the allocation of national income to either
consumption or saving. Thus, the identity (iii) shows that the value of output produced or
sold is equal to the total income received. It is income received that is spent on goods and
services produced.

Now subtracting the consumption (C) from both sides of the identity (iii) we have

IΞYΞS

or I = S

Thus, in our two sector simple economy with neither government, nor foreign trade,
investment is identically equal to saving.

Circular Income Flow in a Three Sector Economy with Government:

In our above analysis of money flow, we have ignored the existence of government for the
sake of making our circular flow model simple. This is quite unrealistic because government
absorbs a good part of the incomes earned by households. Government affects the economy
in a number of ways.

Here we will concentrate on its taxing, spending and borrowing roles. Government purchases
goods and services just as households and firms do. Government expenditure takes many
forms including spending on capital goods and infrastructure (highways, power,
communication), on defence goods, and on education and public health and so on. These add
to the money flows which are shown in Fig. 6.3 where a box representing Government has
been drawn. It will be seen that government purchases of goods and services from firms and
households are shown as flow of money spending on goods and services.
 60

Government expenditure may be financed through taxes, out of assets or by borrowing. The
money flow from households and business firms to the government is labelled as tax
payments in Fig. 6.3 This money flow includes all the tax payments made by households less
transfer payments received from the Government. Transfer payments are treated as negative
tax payments.

Another method of financing Government expenditure is borrowing from the financial

market. This can be represented by the money flow from the financial market to the
Government and is labelled as Government borrowing (To avoid confusion we have not
drawn this money flow from financial market to the Government). Government borrowing
increases the demand for credit which causes rate of interest to rise.

The government borrowing through its effect on the rate of interest affects the behaviour of
firms and households. Business firms consider the interest rate as cost of borrowing and the
rise in the interest rate as a result of borrowing by the Government lowers private investment.
However, households who view the rate of interest as return on savings feel encouraged to
save more.

It follows from above that the inclusion of the Government sector significantly affects the
overall economic situation. Total expenditure flow in the economy is now the sum of
consumption expenditure (denoted by C), investment expenditure (I) and Government
expenditure (denoted by G). Thus

Total expenditure (E) = C + I + G …..(i)

Total income (K) received is allocated to consumption (C), savings (S) and taxes (T). Thus

Y = C + S + T … (ii)

Since expenditure) made must be equal to the income received (Y), from equations (i) and (ii)
above we have

C + I + G = C + S + T … (iii)

Since C occurs on both sides of the equation (iii) and will therefore be cancelled out, we have

I + G = S + T …(iv)

By rearranging we obtain

G – T = S – I … (v)
 61

Equation (v) is very significant as it depicts what would be the consequences if government
budget is not balanced, that is, if Government expenditure (G) is greater than the tax revenue
(7), that is, G >T, the government will have a deficit budget. To finance the deficit budget,
the Government will borrow from the financial market.

For this purpose, then private investment by business firms must be less than the savings of
the households. Thus Government borrowing reduces private investment in the economy. In
other words, Government borrowing crowds out private investment.

Money Income Flows in the Four Sector Open Economy: Adding Foreign Sector:
We now turn to explain the money flows that are generated in an open economy, that is,
economy which have trade relations with foreign countries. Thus, the inclusion of the foreign
sector will reveal to us the interaction of the domestic economy with foreign countries.
Foreigners interact with the domestic firms and households through exports and imports of
goods and services as well as through borrowing and lending operations through financial
market. Goods and services produced within the domestic territory which are sold to the
foreigners are called exports.

On the other hand, purchases of foreign-made goods and services by domestic households are
called imports. Figure 6.4 illustrates additional money flows that occur in the open economy
when exports and imports also exist in the economy. In our analysis, we assume it is only the
business firms of the domestic economy that interact with foreign countries and therefore
export and import goods and services.

A flow of money spending on imports have been shown to be occurring from the domestic
business firms to the foreign countries (i.e., rest of the world). On the contrary, flow of
 62

money expenditure on exports of a domestic economy has been shown to be taking place
from foreign countries to the business firms of the domestic economy.

If exports are equal to the imports, then there exists a balance of trade. Generally, exports and
imports are not equal to each other. If value of exports exceeds the value of imports, trade
surplus occurs. On the other hand if value of imports exceeds value of exports of a country,
trade deficit occurs.

In the open economy there is interaction between countries not only through exports and
imports of goods and services but also through borrowing and lending funds or what is also
called financial market. These days financial markets around the world have become well
integrated.

When there is a trade surplus in the economy, that is, when exports (X) exceed imports (M),
net capital inflow will take place. By net capital inflow we mean foreigners will borrow from
domestic savers to finance their purchases of domestic exports. In this way as a result of net
capital inflow domestic savers will lend to foreigners, that is, acquire foreign financial assets.

On the contrary, in case of import surplus, that is, when imports are greater than exports,
trade deficit will occur. Therefore, in case of trade deficit, domestic consumer households and
business firms will borrow from abroad to finance their excess of imports over exports. As a
result, foreigners will acquire domestic financial assets.

From the circular flows that occur in the open economy the national income must be
measured by aggregate expenditure that includes net exports, that is, X-M where X represents
exports and M represents imports. Imports must be subtracted from the total expenditure on
foreign produced goods and services to get the value of net exports. Thus, in the open
economy

National Income = C + I + G + NX

where NX represents net exports, X-M.

Since national income can be either consumed, saved or paid as taxes to the Government we
have

C + I + G + NX = C + S + T
Methods for Measuring National Income: 3 Methods | Economics
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ADVERTISEMENTS:

The following points highlight the three methods for measuring national income. The
methods are: 1. The Product (Output) Method 2. The Income Method 3. The Expenditure
Method.

1. The Product (Output) Method:

The most direct method of arriving at an estimate of a country’s national output or income is
to add the output figures of all firms in the economy to get the total value of the nation’s
output. The outputs can be grouped into certain product categories corresponding to
industries or to sectors (such as the primary sector, secondary sector and the tertiary sector).
 64

Problems:
When we use the output approach, one major problem arises. This is known as the problem of
double counting. It arises due to the fact that the industry’s output is often the input of
another industry. This is why when we add up the values of all sales, the same output is
counted again and again as it is sold by one firm to another. This problem is avoided by using
the concept of ‘value added’, which is the difference between output value and input at each
stage of production.
 65

In other words, each firm’s value added is the value of its output minus the value of the
inputs that it purchases from other firms. Thus, an automobile manufacturing company’s
value added is the value of its output (i.e., the market value of cars) minus the value of tyres
and tubes, glass, steel batteries it buys from other firms as also the values of any other inputs,
such as electricity and fuel oil that it purchases from other firms.

As Lipsey has put it, “A firm’s output is defined as its value added; the sum of all values
added must be the value, at factor cost, of all goods and services produced by the
economy”.
ADVERTISEMENTS:

While referring to the concept of value added economists draw a distinction between
intermediate goods (like tyres and types which are used as inputs into a further stage of
production) and final goods that are the outputs of the economy after eliminating all double
(multiple) counting and are used for consumption and not for further production.

In our example, tyres and tubes, glass, steel, electricity were all intermediate goods used at
various stages in the production process while cars were final goods. In fact, all investment
products used at various stages in the process lead to the final produce, car.

In short, the output approach measures national output called gross domestic products (GDP)
in terms of the values added by each of the sectors of the economy. To avoid the problem of
double or multiple counting we must either use the value added method or count the total
value of all final products.

Exports:
ADVERTISEMENTS:

If we use the value added method of estimating national output, we have to include exports
but exclude imported materials and services. Imports are automatically excluded since we
only record the values added in this country. This will give us the GDP. In general, the GDP
is measured at market prices, giving the market value of all output. To this, we must add (or
from this we must subtract) the net factor property.

Income from Abroad:

What is the gross national product? GNP is the name we give to the total rupee value of the
final goods and services produced within a nation during a given year. It is the figure one
arrives at when one applies the measuring rod of money to the diverse goods and services—
from computer games to machine tools—that a country produces with its land, labour, and
 66

capital resources and it equals the sum of the money values of all consumption and
investment goods, government purchases, and net exports to other countries.

GNP is used for various purposes, but the most important one is to measure the overall
performance of an economy.

The gross domestic product (or GDP) is the most comprehensive measure of a nation’s total
output of goods and services. It is the sum of the dollar values of consumption, gross
investment, government purchases of goods and services, and net exports produced within a
nation during a given year.

2. The Income Method:

The second approach is to measure incomes generated by production. The main items of
income are shown in Table 1.

Income from employment (item no. 1 in the Table) is wages and salaries. Income of self-
employed persons (item number 2) includes both wages and return on capital owned by self-
employed persons (who are treated as firms in microeconomics). Item number 3 is to be
interpreted in a broad sense. It includes not only the rent of land but also the rent of buildings,
plus royalties earned from patents and copyrights. Thus, it is a partly of return to land and
partly a return to capital. Item number 4 is the major part of return on capital to the private
sector.

Likewise, item number 5 is the major part of the return to capital for the public sector. Item
number 6 is depreciation which is the reduction in the value of capital goods due to their
contribution to the production process. Depreciation or capital consumption allowance
represents that part of the value of output which is not earned by any factor but is the value of
capital used up in the process of production. This depreciation is to be treated as part of the
gross return on capital.

Stock appreciation:
ADVERTISEMENTS:

Item number 8 involves stocks and its appreciation. The first one is concerned with the
valuation of stock of goods produced but not sold in the same year. These are valued at
market prices. This creates a problem in the sense that there is need to record as part of
current output (and income) the profits that will be received by the firm only when, and if at
all, the goods are sold. Thus, if aggregate inventories of Indian companies go down, national
income will raise.
 67

In a year of inflation, it is necessary to make an adjustment for the purely monetary changes
in the value of stocks. It is so because a rise in prices increases the value of existing stocks
even when there is no change in their volume. As G.F. Stanlake has put it, “In order to
obtain an estimate of the real changes in stocks it is necessary to make a deduction
equal to the ‘inflationary’ increase in value.”
This deduction is treated as stock appreciation in the national income tables (see Table 1).
Thus, in order to avoid distortions caused by stock appreciation in an inflationary period, a
correction has to be made to eliminate changes in the value of stocks due to price changes
alone.

As Lipsey has put it, changes in stocks only contribute to changes in GDP when their
physical quantities change. The correction for the change in the value of existing stocks
yields GDP, valued at factor cost and calculated from the income side of the economy. See
Fig.1.

ADVERTISEMENTS:

In short, the income approach measures GDP “in terms of the factor-in- come claims
generated in the course of producing the total output.”
Transfer Income:
When we use the income method we have to exclude all transfer incomes such as
unemployment benefit, widow pension, child benefits or even interest on government bonds.
These are transfer incomes since they are not payments for services rendered — there is no
contribution to current real output by the recipients.
 68

ADVERTISEMENTS:

Thus, while using the income method we must only take into account those which have been
earned for services rendered and in respect of which there is some corresponding value of
output. Interest paid on government bonds is to be excluded for a simple reason.

The government imposes taxes on some people to pay interest to others. But, the total output
(or income) of society does not increase in the process. We may also refer to private transfer
in this context. If you receive a gift from your father who is also a resident of India, India’s
national income will remain unchanged.

Disposable Income:
Factor incomes are normally recorded gross (i.e., before taxes are paid), because this is the
measure of the factors’ contribution to output. If we subtract all direct taxes as also provident
funds contributions and interest paid by individuals on loans (say to HDFC or to Citi Bank
credit cards) from national income we arrive at disposable income. It is so called because
people can dispose it off as they wish.

ADVERTISEMENTS:

Personal Incomes:
National income is not the sum of all personal incomes. The reason is simple. All the income
generated in production does not find its way into personal incomes. A certain portion of
company profit is added to reserves (and not distributed as dividends among shareholders).
Likewise, the profits of public sector (state) enterprises are appropriated by the government
and not by persons. But, these undistributed surpluses must be added on to the total of factor
incomes received by persons to arrive at national income.

Net Factor (Property) Income from Abroad:

It is also to be noted that some of the income derived from economic activity within the
country will be paid to foreign owners of assets located in India, while income from Indian-
owned assets abroad will be moving in the opposite direction. The income account, therefore,
must be adjusted by including the item ‘net income from abroad’. Thus, if you receive a
dividend income $ 1,000 from an U.S. multinational it will be a part of India’s national
income.

Stock Adjustment and Capital Gains and Losses:

Finally, stock appreciation adjustment has to be made in order to eliminate the element of
windfall gain in the profits received. Similarly, capital gains and losses are to be excluded
from national income to avoid double counting. Thus, if you sell shores in the stock exchange
 69

and make a gain of Rs. 100,000 it will not be a part of India’s national income. However, if a
certain portion of it includes factor payment such as broker’s commission it will be a part of
national income.

3. The Expenditure Method:

From the expenditure side national income is calculated by adding up the flows of
expenditure needed to purchase the nation’s output. However, while estimating the value of
national product by the expenditure method we must only record final expenditures.

We have to exclude all the expenditure on intermediate goods and services. While measuring
national income total final expenditure (TFE) is divided into four broad categories:
consumption, investment, government expenditure (spending), exports and imports. These
four components may now be further developed.

Consumption:
Consumption expenditure refers to all purchases by households of currently produced goods
and services, except new houses which are counted as investment. Secondly, consumption of
second hand goods like used cars is to be excluded to avoid double counting. Thirdly, we
have to measure purchases of goods and services made in a year. We need not measure their
actual consumption that occurs during the year (or any other period under consideration).

Investment:
Investment is expenditure on currently produced capital goods like plant and equipment and
housing. Stocks are also included. Investment may be gross or net. Gross investment less
depreciation is net investment, or net addition to (purchase of) society’s stock of capital.

Government Expenditure:
Money that government spends falls into two categories, one is called transfer payments.
These are money paid out for which nothing is given back to the government. One good
example is pension paid to retired people. There is a sort of transfer of money from tax-
payers to the people receiving pensions.

These transfer payments are not part of the GNP, since they do not arise from production. It
is government spending for goods and of services that enters the GNP. Thus, the purchase of
a wagon for the Railway Board and the wages of postal workers are put of the GNP.

Only government expenditure on currently produced goods and services is to be included.

This is known as exhaustive expenditure. All transfer expenditure is to be excluded to avoid
double counting. As Lipsey has put it, “All government payments to factors of production in
 70

return for factor services rendered or payments for goods and services are counted as part of
the GDP.”

Examples are wages and salaries of government employees, government expenditure on

goods purchased from farmers for distribution through the public distribution system (ration
shops) and on medicines purchased from the private sector for distribution through
government hospitals.

Exports and Imports:

Since exports represent foreigners’ expenditure on domestic output these are included in
GDP. Likewise imports are domestic consumers’ expenditure on foreign goods. Hence, they
are not a part of GDP. In the language of Lipsey, “expenditure approach measures the
GDP in terms of the categories of expenditure required to purchase the total output of
society”.
Market Price Measure Vs. Factor Cost Measure:
National expenditure is measured at market prices. These prices differ from the factor cost
values by the amount of taxes and subsidies they contain. Thus, national income at market
price-indirect taxes + subsidies = national income at factor cost. See Fig. 2.

Residual Error:
All these measures of national income are supposed to give the same final figure. Any
discrepancy among the three measures is due to statistical error. This is known as rounding-
up error or residual error, i.e., the error of calculation (not due to any conceptual or
methodological problem).
 71

Problems:
However, various measurement problems crop up in practice.

These are the following:

1. Price Level Changes:
Firstly, price level changes create complications. Such changes make it difficult to compare
the value of output in one year with that of another year. Do we express statistics in terms of
market prices or constant prices?

If in terms of market prices, then figures will be distorted by inflation even though national
output may have remained the same. To overcome this, statistics are often expressed in terms
of constant prices. This means that a particular year’s prices are chosen to calculate the value
of output. In India, for example, 1980-81 is taken as the base year.

2. Public Goods:
Secondly, difficulties arise in case of public goods like road, hospitals, defence, schools, etc.,
which do have market prices. They are parts of GDP because they satisfy human wants and
make use of scarce resources. So, the solution lies in measuring their values ‘at cost’. The
salaries of government school teachers and policemen are taken as a measure of the values of
their outputs.

The education and health expenditures are included at their cost since they are obviously no
different from similar services for which people pay. All government services are therefore
included at cost in national output despite the argument that in some instances this could
amount to double counting because these services are financed out of people’s taxation.

3. Self-Supplied Goods and Services:

Thirdly, people produce same goods and services for themselves. For example, many
teachers teach their own children, farmers produce food for themselves and many people
drive their own cars, and many people even make their own clothes. In such cases, it is not
possible to arrive at a market measurement of the value of the output.

If identical goods and services are sold in the market place it is possible to give self-provided
goods and services an imputed valuation — an estimate of their values can be included in the
national income figures. This method is usually used in case of owner-occupied houses (i.e.,
income from house property).

The market rents of similar properties are used as measuring rod for the imputed rents of
premises occupied by their owners. If there is no reliable market indicator, the assumed
(imputed) value must be an arbitrary estimate or the national income accountant may decide
 72

to omit the commodity (service) from the calculations of the national output. This latter
solution is adopted in case of free services rendered by housewives like coaching their own
children, or cooking food or drawing water from the roadside tube-well or even washing
clothes.

In short, certain goods and services may be provided by a person for himself or herself and it
is very difficult to include these in calculations altogether. Many of these self-supplied goods
and services will be omitted from national income. However, an imputed value is given to
owner occupied houses and an estimate is made of the value of food consumed by farmers
themselves.

Similarly, some goods and services, e.g., services given by housewives, cannot be valued at
all and are omitted. However, this creates a difficulty because a housekeeper’s services are
calculated in national income.

4. Underground Economy:
Moreover, work done in the ‘Black or Underground Economy’, for which there is no official
record, is not included in calculations. This is a serious problem in all market-based
economies.

5. Double Counting:
This problem arises because the outputs of some firms are the inputs of other firms. There are
two possible ways of tackling this problem. Prima facie, national income can be measured by
adding the values of the final products’.

A preferable alternative is to total the values added at each stage of production. Double
counting is a common problem faced by all countries. Transfer payments should not be
included in the calculations of GNP. In addition, from the value of the products of industries
must be deducted the cost of raw materials and products and services provided by other
industries. Only the value added is included. Stock appreciation must also be deducted. This
occurs when the value of stocks increases because of inflation. But, it represents no increase
in real output.

6. Factor Cost:
The value of the national output is measured at factor cost, that is, in terms of the payments
made to the factors of production for services rendered in producing that output. As Stanlake
has put it, “Using market prices as measures of the value of output can be misleading when
market prices do not accurately reflect the costs of production (including profits)”.
 73

In fact, the market prices of most of the commodities that we buy include indirect taxes and
some of them include an element of subsidy. Therefore, if we are to arrive at the factor cost
value, we have to deduct taxes on expenditure and add subsidies to the market price
valuations. It would be misleading to the figures for national income at market prices since it
would mean that the value of national output could be increased by raising the rates of
indirect taxes such as sales tax or excise duty.

So, in spite of the supreme importance of the national income estimates, a lot of difficulties
arise in calculating national income properly.

The following are some major difficulties:

(a) Inadequacy, non-availability and unreliability of accurate data relating to the various
sectors of the economy;

(b) Difficulties of reducing the various, diverse economic activities of the people to a
common measurable denominator;

(c) Difficulties in excluding raw materials and semi-finished goods from the estimates of
national income, in order to avoid the errors of double counting;

(d) Difficulties in discovering true transfer payments (e.g., unemployment allowances or

interest on public debts, relief payments or old-age pensions) for their exclusion from the
national income estimates;

(e) Difficulties in making proper adjustment of the changes in the price-level in the national
income estimates;

(f) Difficulties in treating some major items like government taxes and expenditure, the
earnings from abroad, etc., in calculating the national income;

(g) Difficulties in expressing the national product in terms of money owing to the fluctuations
in the value of money, existence of non-mentioned transactions, unpaid services and non-
monetary economic activities, voluntary work, illegal transactions, etc.; and

(h) Conceptual difficulties in defining national income properly for calculating it with
accuracy. These difficulties are also to be faced in estimating India’s national income.

Summary and Conclusion:

Despite these difficulties involved in the satisfactory calculation of the national income, the
latter serves as a broad indicator of a country’s material welfare and a summary measure of
 74

aggregate economic performances of a country. But, some American writers like William
Nordhaus, James Tobin and Paul Samuelson suggest some readjustments in the traditional
GNP to compute Net Economic Welfare (NEW) “to gauge quality of economic life” and to
get a more meaningful measure of growth in a country.

Measuring National Income (GDP)

 Levels: AS, A Level, IB

 Exam boards: AQA, Edexcel, OCR, IB, Eduqas, WJEC

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National income measures the monetary value of the flow of output of goods and

services produced in an economy over a period of time
GDP and GDP per capita - revision video

Measuring the level and rate of growth of national income (Y) is important for keeping track
of:

 The rate of economic growth

 Changes to living standards
 Changes to the distribution of income between groups within the population

Gross Domestic Product

 Gross domestic product (GDP) is the total value of output produced in a given time
period
 GDP includes the output of foreign owned businesses that are located in a nation
following foreign direct investment. For example, the output produced at the  Nissan
car plant on Tyne and Wear  contributes to the UK’s GDP
 75

Three ways to measure GDP

There are three ways of calculating GDP - all of which in theory should sum to the same
amount:

National Output = National Expenditure (Aggregate Demand) = National Income

(i) The Expenditure Method - Aggregate Demand (AD)

The full equation for GDP using this approach is

GDP = C + I + G + (X-M) where

 C: Household spending on goods and services

 I: Capital Investment spending
 G: Government spending
 76

 X: Exports of Goods and Services

 M: Imports of Goods and Services

The Income Method – adding together factor incomes

GDP is the sum of the incomes earned through the production of goods and services. This is:

 Income from people in jobs and in self-employment (e.g. wages and salaries)

 +
 Profits of private sector businesses
 +
 Rent income from the ownership of land
 =
 Gross Domestic product (by sum of factor incomes)

Only those incomes that are come from the production of goods and services are included in
the calculation of GDP by the income approach. We exclude:

Transfer payments e.g. the state pension; income support for families on low incomes; the
Jobseekers’ Allowance for the unemployed and other welfare assistance such housing benefit
and incapacity benefits

Private transfers of money from one individual to another

Income not registered with the tax authorities Every year, billions of pounds worth of
activity is not declared to the tax authorities. This is known as the shadow economy.

Published figures for GDP by factor incomes will be inaccurate because much activity is not
officially recorded – including subsistence farming and barter transactions

Gross Value Added and Contributions to a nation’s GDP

 There are three main wealth-generating sectors in an economy – manufacturing and

construction, primary (including oil& gas, farming, forestry & fishing) and a wide
range of service-sector industries.
 This measure of GDP adds together the value of output produced by each of the
productive sectors in the economy using the concept of value added. .

Value added is the increase in the value of goods or services as a result of the production
process

Value added = value of production - value of intermediate goods

Say you buy a pizza from Dominos for £9.99. This is the retail price and will count as
consumption. The pizza has many ingredients at stages of the supply chain – tomato
growers, dough, mushroom farmers and also the value created by Dominos as they put the
pizza together and deliver to the consumer.
 77

Some products have a low value-added, for example cheap tee-shirts selling for little more
than £5. These are low cost, high volume, low priced products.

Other goods and services are such that lots of value can be added as we move from sourcing
the raw materials through to the final product. Examples include designer jewellery,
perfumes, meals in expensive restaurants and sports cars. And also the increasingly lucrative
computer games industry.

Manufacturing in the UK was 11% of GDP in 2015.

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Manufacturing in the World Economy

 The creative force behind 10bn unique products

 It accounts for 15-20 per cent of world economy
 It employs about 300m people (roughly 5 pc of world population)

GDP by Output (Value Added)

 The majority of UK GDP comes from service industries such as banking and finance,
tourism, retailing, education and health.
 In 2017, the service industries accounted for 79% of total UK economic output (Gross
Value Added) and accounted for 83% of workforce jobs in September 2017.

Manufacturing

Manufacturing is one of the production industries, which also include mining, electricity,
water & waste management and oil & gas extraction. In 2015, the UK manufacturing sector
accounted for 10% of total UK GDP and it accounted for 8% of jobs.

Service sector industries

 78

The main service sector industries in the UK are:

 Hotels and restaurants, and a range of services provided by local government

 Transport, logistics, storage and communication
 Business services and finance, motor trade, wholesale trades and retail trade
 Land transport and air transport, post and telecommunications
 Real estate activities, computer and related activities, Education, Health and social
work
 Sewage and refuse disposal
 Recreational, cultural and sporting activities

Manufacturing
 79

Services
Difference between GDP and GNP

Per Capita Gross National Income

How much does each person earn on average? We use per capita measures to give us a guide
to this. Income per capita is a way of measuring the standard of living for the inhabitants of
a country.

Gross National Income per capita = Gross National Income / Total Population
 80

Expenditure Method for Measuring National Income: Method, Steps and Precaution

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Expenditure Method for Measuring National Income: Method, Steps and Precaution!
(a) Method:
Expenditure method measures final expenditure on ‘Gross Domestic Product at market price
(GDP at MP) during a period of account.
 81

Since all domestically produced goods and services are purchased for final use either by
consumers for consumption or by producers for investment, therefore, we take sum of final
expenditure on consumption and investment. This sum equals GDP at MP. Final expenditure
is the expenditure made on purchase of domestically produced goods and services for final
use, i.e., for consumption and investment.

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Under expenditure method national income is calculated first by adding up all the items of
final consumption expenditure and final investment expenditure within the domestic
economy The resulting total is called GDP at MR By subtracting depreciation and net indirect
taxes from GDP at MP and adding to its net factor income from abroad, we get NNP at FC or
national income. Thus, under expenditure method, national income is measured at the point
of actual expenditure.

Mind, income generated by factors of production in the production process is spent by them
on final goods. Final use of a commodity is either for consumption or for investment and
expenditure on them is called Final Consumption Expenditure and Final Investment
Expenditure, respectively By adding up all the items of final consumption expenditure and
final investment expenditure within the domestic economy, we get the aggregate called GDP
at MP

(b) Steps involved:
Expenditure method involves the following steps:
(i) Identification of economic units incurring final expenditure, e.g., household (or
consuming) sector, firm (or producing) sector and government sector.

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(ii) Classification of final aggregate expenditure into following components:

1. Private final consumption expenditure.

2. Government final consumption expenditure.

3. Gross fixed capital formation.

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4. Change in stocks.
 82

5. Net exports.

(iii) Measurement final expenditure on the above components. Sum total of the above five
items gives us the value of GDP at ME By deducting depreciation and net indirect taxes from
GDP at MP we get NDP at FC.

(iv) Estimation of net factor income from abroad which is added to NDP at FC (Domestic
Income) to obtain NNP at FC (National Income).

(c) Precautions:
The following precautions need to be taken for correct estimation of national Income by
expenditure method.

Alternatively, following items of expenditure should not be included:

(i) To avoid double counting, expenditure on all intermediate goods and services is excluded.
For example, purchase of vegetables by a restaurant, expenses on electricity by a factory, etc.,
are not included as they are for intermediate consumption.

(ii) Government expenditure on all transfer payments such as scholarships, unemployment

allowance, old-age pension, etc. is excluded because no productive service is rendered by the
recipients in exchange.

(iii) Expenditure on purchase of second-hand goods is excluded from national income

because this type of expenditure is not on currently produced goods.

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(iv) Expenditure on purchase of old shares/bonds or new shares/bonds, etc. is excluded

because it is not payment for goods or services currently produced. It shows mere transfer of
property from one person to another. Likewise, gifts from abroad which bring transfer
payment are not included.

(v) Imputed expenditure on own account output (e.g., owner occupying his house, self-
consumed output by a farmer) should be included.
Top 6 Difficulties Faced in Computation of National Income

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 83

Here we detail about the six major difficulties faced by a country during computation of
national income.
1. Types of Goods and Services:
The kinds of goods and services which should be included in national income pose a
problem.

Goods and services having money value are included in the national income but there are
goods and services which may have no corresponding flow of money payments.

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Services which are performed for love, kindness and mercy and not for money have an
economic value but have no money value.

The difficulty is whether these services should be included in national income and how to
measure their money value, e.g., a paid maid servant’s services are included in the national
income but later when she marries the master, she is not paid any more, though she continues
to perform the services. There is, thus, a reduction in the national income.

Similarly, when a housewife cooks for the family, her activity is not included in the GNP.
But when she cooks in a restaurant and gets paid, her services are included in GNP. Much of
the activity, goods and services which have money value and are considered economic in
U.K. and U.S.A. on the basis of their marketability, are treated as non- economic in India
because they are carried on in the household sector.

However, it is a general principle to exclude such household activities of housewives, home

repairs, washing, cleaning, shaving or ‘do it yourself activities from national income because
of the great practical difficulties in valuing the output resulting from these activities.

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It is for this reason that any comparison of the GNP between highly developed market
economy and an under-developed economy (in which a good part of the national product
remains outside the market) is rendered useless. It is, therefore, impossible to include the
value of personal services rendered to oneself in the national product or income accounts.

2. Problems of Double Counting:

Another difficulty is of double counting usually associated with the inventory method.
Double counting implies the possibility of a commodity like raw material or labour being
included in national income more than once, e.g., a farmer sells maize worth rupees two
 84

hundred to a mill-owner, the mill owner further sells the maize flour to a wholesale dealer,
who further sells it to consumer; if we calculate it at every stage, its money value will
increase to eight hundred rupees but actually the increase in national income has been to the
extent of two hundred rupees only.

The best way to avoid this difficulty is to calculate only the value of all goods and services
that enter into final consumption. The problem of differentiating intermediate and final
products is very complex and acute in the computation of national income. For example,
expenditure incurred on the purchase of goods and services by the government like
expenditure on wages and salaries of government employees who perform services like
police, military, fire protection etc. are all included in GNP estimates.

Some economists, however, argue that the purchase of these services or expenditures incurred
on such services is actually intermediate to the production of final goods and should not be
included in GNP estimates because they are not final products. Such expenditure are essential
simply to create and provide the conditions under which the business and other sectors could
perform day-to-day productive activities. It is very difficult to separate and distinguish
between government services which are of intermediate nature and which are in the nature of
final product. On this ground alone, the national income accounts include practically product.

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On this ground alone, the national income accounts include practically all services provided
to the business and other sectors by the government as part of final product and the value of
these services in any period is in effect measured by the total amount of government
expenditure during the period for the purchase of goods and labour used to provide
governmental services. The same problem arises in classifying all purchases of consumer
goods and services as final product.

Expenditures by persons on food, clothing, education, medical, transportation, recreation etc.

are in part necessary to the performance of their jobs as producers in the economy. Therefore,
some of these expenditures, at least, in a sense, are really for intermediate product; but it is
impossible to draw a line of separation. It is for this reason that all purchases of goods and
services by persons are classified as final product in actual practice in the income accounts.
We thus see that final product is not some definite quantity that is available awaiting
measurement by statisticians.

3. Excluded Market Transactions:
 85

Certain transactions that take place in the market are excluded from the computation of
national income because they violate the general rule for the recognition of income—the
good or service must be currently produced and must use up currently available scarce
resources. Many transactions are such that represent merely the transfer of wealth (or claims
to wealth) or the exchange of commodities produced in some previous accounting period.

These excluded transactions relate to transfer payments, capital gains, illegal activities,
second hand sales etc.:
(a) Transfer Payments:
Transfer payments are associated with the income method of national income calculation. A
person receives income of say Rs. 1,000 per year; part of it may have been received as
interest payments on government loans. This part is in the nature of transfer payments and
may be taken either as the income of the individual or of the government. If it figures under
both the categories, aggregate national income will be unduly inflated.

Therefore, the transfer of money from one person or group to another person or group should
be avoided and the best way to solve this difficulty is to consider only the disposable income
of individuals or groups i.e., personal incomes minus all transfer payments. Transfer
payments or receipts refer to those income payments which are not the result of any current
productive activity on the part of income receivers. These transfer payments are made by
individuals, business firms and government in an economy.

For example, when a business firm distributes Rs. 1,000 in prize money in a competition
contest held by it to popularize its product, the prize money is income for the prize winners—
this prize income, however, is different from factor income. Similarly, the expenditure of Rs.
1,000 does not represent the factor cost of production for the firm because it has not been
paid to the factors of production against the productive services rendered by them.

Transfer payments represent merely a transfer or redistribution of income from person to

person, from firms to persons or government and from government to persons and business
firms. These transfer payments do not represent payments made for productive services
rendered in the production of final goods and services, they are, therefore, excluded from
national product. Examples are social security payments like pension, direct relief payments
like unemployment allowances, prize, money of business firms, interest on government
debts gifts, charity payments, awards, scholarships etc.
(b) Capital Gains:
Capital gains or losses represent increases in the value of the capital assets resulting from a
rise or fall in the market prices of such assets. These gains or losses which are caused by
changes in the valuation of assets are excluded from national income accounts because they
 86

do not represent any increase or decrease in the national product flow stream on account of
productive activity rendered. If the market value of land or buildings rises on account of
inflation, the owners no doubt will gain.

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But from a macroeconomic accounting viewpoint, such gains are immaterial and do not
matter because the real estate of the economy, thereby, does not increase. The increase in the
value of land due to a mere rise in prices is basically different from the increase in the value
of land resulting from improvements made on it. These improvements like planting, digging a
well, leveling etc. represent current flow of productive activities as such the increase in the
value of land will be included in the national income accounts but not otherwise; if it is
merely a change gain or a windfall. Capital gains, which do not accrue to asset owners
against productive services rendered are not included in the national income.

(c) Illegal Activities:

All unlawful and illegal activities, whether economic or not, are omitted from national
income accounting. Income earned through illegal activities like smuggling, black-
marketing, gambling, betting, adulteration, bribery etc. are excluded on the ground that these
activities are illegal and, therefore, cannot be included in the national income accounts.
However, it is very difficult to estimate such activities because their definitions or notions
may change from generation to generation or from society to society. In a free market
economy—who is going to say or decide— what is a socially desirable or lawful activity?
Thus, it is the larger issue of what constitute a lawful or socially desirable activity that
demands closer examination.

(d) Second-hand Sales:

The most obvious item for exclusion from the national income and product accounts is
second-hand sales. In such sales the individual or the economic units merely exchange
ownership of an already existing good, when no income is created in the process from current
production. Even if a profit is made, there is no income generated in the accounting sense, for
the gain is offset by the recording of the good at the transaction price by the buyer.

In short, the entire transaction has to be ignored—gain or loss. If, however, a reward is
offered to someone who brings the buyer and seller together, the reward is recorded as
income. The function of creating a market is a legitimate economic activity, uses scarce
resources, hence the reward for this function is clearly income. The functions of the broker,
used car salesmen, dealers of many kinds, auctioneers, are a few examples.
 87

4. Problem of Imputed Values:

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There are certain goods and services which do not appear in or cannot be brought to the
market. In such cases we have to impute values to them. It means to give or to fix their
values, in case they had been brought to the market. The procedure although very logical yet
is beset with number of practical difficulties because the task of imputing or fixing values is
not easy. But, values, once they are imputed or fixed are included in the national income
accounts.

Crops raised on the farm like wheat, rice, etc. and consumed by the farmer and his family on
the farm, person living in his own house, services rendered by commercial banks, insurance
companies and other financial institutions, ‘fringe benefits’ enjoyed by the well paid top
business executives of big companies and corporations like a managing director—receiving
in addition to his salary, ‘fringe benefits like free residence, future, conveyance, medical
allowances etc.

The true monthly income of the managing director will be the imputed money value of fringe
benefits enjoyed by him plus the monthly salary. Thus, when some goods and services,
representing current economic activity in the economy do not appear on the market, an
imputed value equal to the market value of similar goods and services is assigned to them for
purposes of including the value of these goods and services in the national product and
income accounts.

But, it is easier said than done. The problem of imputing values is not easy. For example,
how the fringe benefits are to be valued because their value is different under different
circumstances and the prices at which these benefits are available also keep on changing.
Again, the services of a judge, a police officer, street lighting etc. cannot be purchased
because they are not placed in the market as such.

5. Inventory Adjustments:
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Inventory adjustments i.e., changes in the stock of capital goods or final products are also to
be taken into account while computing national income. If a jute mill adds to its inventory of
jute products during the year, it represents an increase in output and must, therefore, be
included in GNP. The difference between the officially published figures and the figures
obtained from the business accounting data calls for inventory valuation adjustment. On
account of the change in the physical volume of inventories and the change in the prices at
 88

which these inventories are valued by business units, inventory valuation adjustment becomes
essential.

The main purpose of this adjustment on the product side of the national income and product
account is to avoid understating or overstating the change in inventories and, therefore, to
avoid understating or overstating the gross domestic investment and the gross national
product. The difficulty arises on account of the fact that all business units do not keep a
record of the changing inventories, and even those who do maintain the record not in physical
units but in terms of value. Since inventories have to be carried over several periods, their
valuation presents a difficult problem due to frequent changes in prices also. Moreover,
business units keep their records of inventories in terms of original cost.

6. Depreciation:
Depreciation implies a reduction in the value of capital stock or capital goods due to wear and
tear, constant use etc. During the process of production the wear and tear or capital
consumption occurs, resulting in, at the same time, a decline in the relative efficiency of the
plant and equipment on account of obsolescence. However, the problem of correctly
estimating depreciation is equally a difficult task e.g., a machine may be used more
intensively in one year than the other. But the rate of depreciation remains the same, though it
should differ between two years. Again, the depreciation of similar equipment may differ
between two business units.

Moreover, a good part of the annual depreciation may actually represent obsolescence rather
than the physical wear and tear of capital equipment. In periods of rising prices, the amount
of depreciation may fall short of the amount needed to replace capital, which in turn, may
mean under-statement of depreciation and over-statement of profits, thereby, unduly inflating
the NNP.

ADVERTISEMENTS:

Therefore, the estimates of depreciation on the basis of replacement cost of the assets are
superior because they provide better estimates of net investment in the community. It is,
therefore, clear that once the difficult problems like double counting, inventory valuation,
depreciation etc. are resolved satisfactorily, accurate estimates of national income and
product account become easier.
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Difficulties of Measuring National Income (4 Problems)

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The measurement of national income in any country is beset with many problems.

Problems are more acute in LDCs like India than advanced countries.

These problems are grouped into two: (i) conceptual or theoretical problem, and (ii) practical
or statistical problem. However, as there is no escape route to avoid all the conceptual
problems, we set aside these problems and consider only practical problems.

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Some of the difficulties in measuring national income are as follows:

1. Lack of Reliable Data:
The reliability of data relating to national income estimation is often questioned (in India).
National income estimate is made on the basis of primary data relating to incomes and values
of goods produced. It is observed that many producers —particularly petty producers and
traders— do not maintain any accounts of their incomes and even goods produced.
Obviously, the primary data collected from this source is supposed to be vague. The reason
behind this is illiteracy. Further, many people are reluctant to cooperate with the data
collectors. Above all, data collectors often ‘fabricate’ data even without approaching the door
of producing sectors or economic units. If this information is considered to be the basis of
judgement, then the judgement will suffer from inaccuracy.

2. Existence of Non-Monetised Sector:

The soundness of national income estimates is affected badly if there exists a large non-
monetised sector. This creates valuation problem. In an LDC, there exists an unorganised
barter economy where money is not used for transaction purposes.

In each transaction, the problem of valuation of goods transacted crops up. Further, poor
farmers of these countries retain large chunks of their output for self-consumption. Naturally,
a large amount of output does not come to the market and is not subject to the valuation
process. By imputing values to these goods, the problem of valuation can be partially
 90

removed. But considering the vastness of a country like India, such imputation is an uphill
task. Even if imputation is possible, its reliability is also doubted.

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Various non-market and domestic activities like child care by mothers and sisters are not
taken into account while estimating national income of a country, for the said reasons. In fact,
these activities add to production when we engage the services of a lady ayah who takes care
of a child against some monetary payments. But these are not considered in view of the
difficulties of estimating such income.

Further, in national income estimation, looses or social ills do not get reflected. C02 emission
from automobile car pollutes the environment resulting in fewer ‘outputs’ for future
generations. Such is not adjusted usually, although attempts are often made to measure ‘green
GNP’.
3. Difficulties in the Classification of Working Population:
In India, working population is not clearly defined. For instance, agriculturists in India are
not engaged in agriculture round the year. Obviously, in offseason they engage themselves in
alternative occupations. In such a case, it is very difficult to identify their incomes to a
particular occupation.

4. Illegal Income:
Finally, illegal incomes are not reported in national income accounts. In other words, illegal
forms of economic activity and illegal activities that are not reported to the authority for the
purpose of paying taxes are left out from national income accounts.

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This is what is called underground or black economy. Gambling and drug trade are illegal
forms of economic activities while people in power receive bribes but these people either
underreport or do not report the bribed incomes that are illegal. In India, incomes generated
in India’s black economy are estimated to be around 40 p.c. of GDP. Such transactions
underestimate the true Home » Questions and Answers » Business Studies QA » 9 Uses of
National Income Statistics and Methods of Measuring
9 Uses of National Income Statistics and Methods of Measuring
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What follows is a list of uses of National Income statistics, some of the methods of measuring
it and a definition of what national income statistics are.
 91

9 Uses of National Income Statistics and Methods of Measuring data/Photo Source

What are National Income Statistics?  

National Income Statistics is data generated from the value of goods and services produced
by a country’s economy.

3 Methods of Measuring National Income

The three methods of measuring Nation income are;

 Value added (Product Method)

This methods involves calculating the contribution of each business in the domestic territory
of a country. This therefore means that you must first have to identify and classify the
business before you start measuring them.

 Income

This involves revenue generated from the primary factors of production. For example labor
earns salary, entrepreneur gets profit, land gets rent and capital get interests.

 Expenditure

This is the alternative way of measuring nation income. It involves expenditures on

government purchases, individual consumption and  private firms investment.

List of Uses of National Income Statistics

Below is a list of National Income statistics;

1. Provides information on the country’s economic performance over a period of time.

2. Provides information to be used for making economic policies or budgeting or
planning.
3. Provides information on the contribution of each sector of the economy to the national
income.
4. Provides a breakdown on consumer expenditure and government expenditure.
5. Provides information on the distribution of income.
6. Provide information on the types of factor incomes in the economy.
7. Provide statistics for measuring the economic growth of the country.
8. Provides information that is used to measure the standard of living in the country.
9. Provide information used for comparing economic performance of the country across
two or more years.

To Learn more about National Income read this resourceful Economic Journal
titled : Definition Of National Income
 92

You can also read  8 Solutions for Government on How to reduce unemployment Rate

Do not miss all our latest updates on benefits of National Income Statistics to government
and how to calculate it using technology

value of national income of any country.

Top 5 Uses of National Income Data | Economics

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The following points highlight the top uses of national income data. The uses are: 1.
Population 2. Composition of output 3. Distribution of income 4. Different national
currencies 5. Statistical limitations.

Use # 1. Population:
A higher national income clearly does not mean a higher standard of living if the extra
income is shared among more people. The standard of living depends on the average real
income per head or per capital — that is, real national income divided by the population.

Use # 2. Composition of Output:

In ancient Egypt productive resources were wasted on building pyramids. Similarly, a
modern society may use a large part of its resources for military purposes that contribute little
to the welfare of the people. Moreover, societies differ in their needs.

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For example, a cold country has to use a portion of its productive capacity just to keep warm.
At a particular time much of a countries output may be used to repair damages due to floods
or earthquakes. Thus, the output that is available for satisfying other needs will fall.

Use # 3. Distribution of Income:

The wealth of a country may belong to only a small number of very rich people and so a high
national income can conceal widespread poverty. Living standards within a society depend
partly on how wealth and income are shared among the people.
 93

Use # 4. Different National Currencies:

In order to compare the national income of different countries, it is necessary to covert the
figures into the same currency. For instance, the United States’s figures are in dollars whereas
Britain’s figures are in pounds sterling. To compare them, we must either change the former
into pounds of the latter into dollars. This is done by using the exchange rate at which pounds
can be changed into dollars.

For example, at a rate of £1 to $2, a UK national income of, say, £100 billion would be
expressed as $200 billion. If the USA national income is then $400 billion, it would be taken
as double that of the UK. But this assumes that £1 can actually buy the same amount of goods
in Britain as it could if changed into $2 and spent in the United States. However, in reality
currency exchange rates are rarely such an accurate reflection of prices. International
comparisons of this kind can therefore be misleading.

Use # 5. Statistical limitations:

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Methods of calculation and reliability of national statistics inevitably vary, particularly

between countries at different stages of economic development. Thus, the welfare of people
in a less developed farming community may be underrated by national income figures
because production is based largely on family self-sufficiency and not measurable in money
terms. Even in advanced economies the measurements can be misleading because they take
no account of non-monetary exercises such as the do-it-yourself activities of Indian
households.
Keynesian Theory of National Income Determination

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According to Keynes, there can be different sources of national income, such as government,
foreign trade, individuals, businesses and trusts.

For determining national income, Keynes had divided the different sources of income into
four sectors namely’ household sector, business sector, government sector, and foreign
sector.

He prepared three models for the determination of national income, which are shown in
Figure-1:
 94

The two-sector model of economy involves households and businesses only, while three-
sector model represents households businesses, and government. On the other hand, the four-
sector model contains households, businesses, government, and foreign sector.Let us discuss
these three types of models of income determination given by Keynes.

Determination of National Income in Two-Sector Economy:

The determination of level of national income in the two-sector economy is based on an
assumption that two-sector economy is an economy where there is no intervention of the
government and foreign trade.

Apart from this, an economy can be a two-sector economy if it satisfies the following
assumptions:
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a. Comprises only two sectors, namely, households and businesses. The households are the
owners of factors of production and provide factor services to businesses to earn their
livelihood in the form of wages, rents, interest, and profits. In addition the households are the
consumers of final goods and services produced by businesses. On the other hand, businesses
purchase factor services from households to produce goods and services and sell it to
households.

b. Does not have government interference. If government is there, it does not have any role to
play in the economic activity of a country. For example, in the two-sector economy, the
government is not involved in activities, such as taxation, expenditure, and consumption.

c. Comprises a closed economy in which the foreign trade does not exist. In other words,
import and export services are absent in such an economy.

d. Contains no profit that is undistributed or savings by the organization. In other words, the
profit earned by an organization is completely distributed in the form of dividends among
shareholders.
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e. Keeps the prices of goods and services, supply of factors of production, and production
technique constant throughout the life cycle of organization.

Keynes believed that there are two major factors that determine the national income of a
country. These two factors are Aggregate Supply (AS) and Aggregate Demand (AD) of
goods and services.

In addition, he believed that the equilibrium level of national income can be estimated when
AD=AS. Before representing the relationship between AS and AD on a graph, let us
understand these two concepts in detail.

Aggregate Supply:
AS can be defined as total value of goods and services produced and supplied at a particular
point of time. It comprises consumer goods as well as producer goods. When goods and
services produced at a particular point of time is multiplied by the respective prices of goods
and services, it provides the total value of the national output. The national output is the
aggregate supply in the form of money value. The Keynesian AS curve is drawn based on an
assumption that total income is equal to total expenditure. In other words, the total income
earned is fully spent on different types of goods and services.

The correlation between income and expenditure is represented by an angle of 45°, as

shown in Figure-2:

According to Keynes theory of national income determination, the aggregate income is

always equal to consumption and savings.

The formula used for aggregate income determination:

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Aggregate Income = Consumption(C) + Saving (S)

Therefore, the AS schedule is usually called C + S schedule. The AS curve is also named as
Aggregate Expenditure (AE) curve.

Aggregate Demand:
AD refers to the effective demand that is equal to the actual expenditure. Aggregate effective
demand refers to the aggregate expenditure of an economy in a specific time frame. AD
involves two concepts, namely, AD for consumer goods or consumption (C) and aggregate
demand for capital goods or investment (I).

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Therefore, the AD can be represented by the following formula:

AD = C + I

Therefore, AD schedule is also termed as C+I schedule. According to Keynes theory of

national income determination in short-run investment (I) remains constant throughout the
AD schedule, while consumption (C) keeps on changing. Therefore, consumption (C) acts as
the major determinant or function of income (Y).

The consumption function can be expressed as follows:

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C = a + bY

Where, a = constant (representing consumption when income is zero)

b = proportion of income consumed = ∆C/∆Y

By substituting the value of consumption in the equation of AD, we get:

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AD = a + bY + I

Let us prepare an AD schedule by assuming that the investment is Rs. 50 billion and
consumption function of a product is:
C = 50 + 0.5 Y

Therefore, aggregate demand would be:

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AD = a +b Y + I

AD = 50 + 0.5 Y + 50

AD= 100 + 0.5 Y

The aggregate demand schedule at different income levels is represented in Table-1:

In Table-1, the column of income represents the aggregate supply and the column of
aggregate demand represents expenditure. In Table-1, it can be noticed that at Rs. 200 billion
of income level, aggregate supply and aggregate demand are equal. Therefore, Rs. 200 billion
is the equilibrium point for the two-sector economy.

Figure-3 represents the graphical representation of national income determination in

the two-sector economy:

In Figure-3, while drawing AS schedule it is assumed that the total income and total
expenditure are equal. Therefore, the numerical value of AS schedule is one. AD schedule is
prepared by adding the schedule of C and I. The aggregate demand and aggregate supply
intersect each other at point E, which is termed as equilibrium point.

The income level at point E is Rs. 200 billion, which represents the national income of the
economy. The schedule curve after point E represents that the AS is greater than AD (AS >
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AD). In such a situation, the products and services are costing more than Rs. 200 billion;
therefore, households are not willing to buy them.

Therefore, the supply of products and services exceeds their demand. As a result, businesses
would have a pile of unsold stocks. For example, in Table-1, when the income or aggregate
supply is at Rs. 300 then the aggregate demand or expenditure is Rs. 250, which is less than
the aggregate supply.

Similarly, beneath point E, the AD and AS schedules represent that the aggregate demand is
more than aggregate supply. In such a case, the production by businesses is less than the
demand of households. Therefore, businesses start producing more and more products and
services. For example, in Table-1, when the income or aggregate supply is Rs. 100 then the
aggregate demand is Rs. 150, which is more than the aggregate supply.

The equilibrium condition of national income determination can be expressed as

follows:
Aggregate demand = Aggregate supply

C + I = C-HS

Therefore, I = S

Thus, the national income can be determined by using either aggregate demand and aggregate
supply schedules or investment and savings schedules. These two methods of income
determination are classified as income-expenditure approach and saving- investment
approach.

Income-Expenditure Approach:
Income-expenditure approach refers to the method in which the aggregate demand and
aggregate supply schedules are used for the determination of national income.

In this method, the equilibrium point is achieved when the following condition is
satisfied:
C+I=C+S

As, C + S = Y, therefore, the equilibrium condition of national income determination

would become:
Y=C+I

At equilibrium point, the consumption is equal to:

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C = a + bY

Substituting the value of C in the national income equilibrium condition, we get:

Y = a + bY + I

Or, Y (1- b) = a + I

Thus, Y = 1/1-b (a + I)

For the determination of national income with the help of income-expenditure approach, let
us assume that the consumption function is C = 200 + 0.50Y and I = 150.

In such a case, the national income can be calculated as follows:

Y=C+I

Y = 200 + 0.50Y+ 150 1

Y = 1/1-0.50(200 + 150)

Y = 1/1.50(350)

Y = 700

Therefore, the national income equilibrium in this case is at Rs. 700. The graphical
representation of national income determination with the help of income-expenditure
approach is shown in Figure-4:

In Figure-4, the schedule of C + S shows the aggregate supply of income while the C + I
schedule denotes the aggregate demand. Aggregate demand schedule is drawn by adding C
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and I schedules. Aggregate demand and aggregate supply schedule intersect each other at
point E and the Income level at this point is Rs. 700.

This implies that the national income in the two-sector economy is Rs. 700. In short-run, the
equilibrium point remains constant that is the level of national income remains constant. If
there is any type of increase or decrease in the aggregate supply/demand, then they
themselves fluctuate in a manner, so that they reach back at the equilibrium point.

Saving-Investment Approach:
Saving-investment approach refers to the method in which the saving (S) and investment (I)
are used for the determination of national income. The condition for achieving equilibrium
with the help of saving-investment approach is that the saving and investment are equal (I =
S).

Let us take the previous assumption that consumption function is equal to C = 200 + 0.50 Y
and I = 150 for the determination of national income by using the saving-investment
approach.

In such a case, the saving function can be determined as follows:

Y=C+S

Or,

S = Y-C

S = Y – (a + bY)

S = Y – a – bY

S = -a + (l-b) Y

Therefore, in the present case, the saving function would be:

S = -200 + (1 -0.50) Y

S = – 200 + 0.50 Y

At equilibrium point I = S, therefore, the national income equilibrium would be:

150 = -200 + 0.50 Y

Y= 700
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The national income level at equilibrium point is same in both the cases, income-expenditure
approach and saving-investment approach. Figure-5 provides a graphical representation of
national income determination by using the saving-investment approach:

In Figure-5, equilibrium point is at E where the investment and saving curve intersects each
other. The national income at equilibrium level is Rs. 700.

Shifts in Aggregate Demand Schedule:

In the above, you have learned to determine the equilibrium level of national income under a
given AD schedule that is C+I. A shift in aggregate demand schedule can produce changes in
the equilibrium level of national income in the two-sector economy. Therefore, it is necessary
to study and understand the shifts that arise in AD schedule and determine measures to get
the equilibrium position back. In a two-sector economy, a shift in AD schedule occurs due to
a shift in consumption or investment schedule or in both, simultaneously.

However, shifts in consumption schedule are very rare as it is an income function, whereas
investment schedule can fluctuate because of autonomous factors, such as risks and
individual perceptions. Therefore, the shift in AD schedule is because of the shifts in
investment schedule.

For understanding the impact of shift in AD schedule on equilibrium point, let us assume that
the AD schedule is showing an upward shift due to a permanent upward shift in the
investment schedule. The investment schedule is shifting due to the autonomous investment
in some venture. As a result, the equilibrium point also shifts in the upward direction and the
national income also increases.

Figure-6 demonstrates the shift in national income due to shift in equilibrium point and
AD schedule:
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In Figure-6, C + I schedule represents the initial AD schedule. The initial equilibrium is at

point E, where C+S schedule or AS schedule intersects AD schedule and the level of national
income is Y1. Suppose investment increases, which leads to a movement in the investment
schedule from I to I + ΔI, showing an upward shift. Consequently, the AD schedule also
moves from C + I to C + I + ΔI. With the shift in AD schedule, the equilibrium point reaches
to E2 and level of national income reaches to Y2.
The increase in national income can be calculated as follows:
ΔY = Y2 –Y1
The national income increases due to increase in the investment. Let us determine the
relationship between change in national income (ΔY) and change in investment (ΔI) by
understanding the concept of multiplier given below.

Concept of Multiplier:
The concept of multiplier can be understood by determining the relationship between change
in national income (ΔY) and change in investment (ΔI).

According to Figure-6, at equilibrium point E1, the national income is as follows:

Y1 = C + I
The consumption is equal to:
C = a + bY

By substituting the value of C in the equation of national income at point E1, we get:
Y1 = a + bY1 + I
Y1 = 1/1-b (a + I)
Similarly, at equilibrium point E2, the national income would be:
Y2 = C + I + ΔI
Y2 = a + bY2 + I + ΔI
Y2 = 1/1-b (a + I + ΔI)
By subtracting Y1 from Y2, we get:
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ΔY = 1/1-b (a + I + ΔI ) – Y2 = 1/1-b (a + I)

ΔY = 1/1-b ΔI

The preceding equation of ΔY determines the relationship between ΔY and ΔI. It implies that
ΔY is 1/1-b times of ΔI and 1/I-b is termed as multiplier (m).

The formula used for calculating multiplier is as follows:

ΔY/ΔI = 1/1-b

So, m = 1/1-b

In mathematical terms, the multiplier is defined as the ratio of change in national income that
occurs due to change in investment. It is also termed as investment multiplier because change
produced in national income is due to change in investment.

As discussed earlier that b can be calculated with the help of the following formula:
b = ΔC/ΔY

This is the equation of Marginal Propensity to Consume (MPC). Therefore:

MPC = b = ΔC/ΔY

Thus, it can be said that MPC is the determinant of multiplier value. The value of multiplier
would be higher if the value of MPC is greater.

The relationship between m and MPC can be represented as follows:

m = 1/1-b

m = 1/1-MPC

Table-2 represents the value of multiplier for different values of MPC:

Multiplier can also be calculated with the help of Marginal Propensity to Save (MPS).

So, the formula for calculating multiplier with the help of MPS is as follows:
m = 1/MPS = 1/1-MPS
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Therefore, multiplier can also be termed as the reciprocal of MPS.

The multiplier can be of two types on the basis of its application.

The two types of multiplier are explained in the following points:

(a) Static Multiplier:
Refers to a multiplier in which it is assumed that the change in investment and income are
simultaneous. There is no time lag between change in investment with respect to change in
income. For example, in Figure-6, the shift in the equilibrium position from E1 to E2 is the
result of change in investment (ΔI) without any time lag.
In case of static multiplier, when the equilibrium position shifts from one point to another, the
aggregate MPC does not show any change. In addition, it is also assumed that the consumer
tastes and preferences and income distribution remains constant. It is also called comparative
static multiplier, simultaneous multiplier, logical multiplier, timeless multiplier, and lagless
multiplier.

(b) Dynamic Multiplier:

Refers to the multiplier that analyzes the movement of equilibrium position from one point to
another. In a logical sense, there is a time gap between an increase in income with the
corresponding increase in autonomous investment. The income cannot rise immediately when
an autonomous investment is made because there is always a time lag in increase in income
and consumption expenditure.

Let us understand the process of dynamic multiplier with the help of an example. Suppose the
autonomous investment increases by Rs. 100 and MPC is equal to 0.8, with no expenditure,
except consumption expenditure.

The increase in investment would result in the equal increase of income, which is
described as follows:
ΔI = 100 = Δy1
When the income of individuals increases to Rs. 100, the consumption expenditure is Rs.
80(= 100*0.8) Now, the expenditure of Rs. 80 would become the income for suppliers;
therefore, an additional income for suppliers would be Δy2 = Rs. 8o. Consequently, suppliers
would spend Rs. 64 (=80*0.8).
This produces an additional income for suppliers of consumer goods and services that is’
equal to Δy3 = Rs. 64. The additional income continues to produce till the value of change in
income. Δy reaches to zero. In the process, the value of Δy decreases continuously from
Δy1 > Δy2 > Δy3 to Δyn-1.
The calculation of ΔY is shown as follows:
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ΔY= Δy1 + Δy2 + Δy3 + Δy4 … Δyn-1

ΔY = 100 + 100 * (0.8) + 100 * (0.8)2 + 100 * (0.8)3……. + 100 * (0.8)n-1
ΔY = 100 + 80 + 64 + 51.20………→ 0

ΔY= 500

The value of multiplier can be obtained by using the following formula:

m = ΔY/ΔI

m = 500/100

m=5

The series of national income can be generalized as follows:

ΔY = Δy + Δy (b) + Δy (b) 2 + Δy (b) 3………… Δy (b) n-1
ΔY= Δy (1 + b + b2 + b3 …………….. bn-1)
ΔY = Δy 1/1-b

As Δy = ΔI; therefore, the formula of national income can also be written as follows:
ΔY = ΔI1/1-b

Thus, the formula of dynamic multiplier is as follows:

m = ΔY/ΔI = 1/1-b

Limitations of Multiplier:
Apart from its important uses in macroeconomics, the multiplier also has certain limitations.

Some of the limitations of multiplier that need to be considered while using the concept
are as follows:
(a) Based on MPC:
Refers to the main limitation of multiplier. The value of multiplier depends upon the rate of
MPC. Therefore in case the rate of MPC is lower, the value of multiplier would also be
lower. Generally as compared to developed countries rate of MPC is higher in developing
countries or less developed countries. Therefore, the value of multiplier is also higher in
developing countries. However, it is not true in practical situations.

(b) Assumption of income and investment:

Refers to the fact the theory of multiplier is based on an assumption that additional income
earned by individuals as a result of some autonomous investment is spent on the consumption
of goods and services only which is not the real concept. Individuals can spend their
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additional income on various resources, such as clearing dues buying second-hand goods, and
purchasing imported goods and shares and debentures.

All these resources are termed as leakages in the flow of consumption, which adversely affect
the rate of multiplier. For example suppose Mr. A earns Rs. 1, 00,000 from a contract. He
pays money to the creditor, Mr. B of his contract. Mr. B buys a second hand car with that
amount from Mr. C. Further, Mr. C deposits the money in a foreign bank.

In this way, the money circulates but the demand for new consumer goods and services is not
generated. In such a case, the rate of multiplier would be one. The other forms of leakages are
idle cash and foreign deposits.

(c) Assumption of adequate supply:

Refers to another major limitation of multiplier. The theory of multiplier is based on an
assumption that goods and services are abundant and there would be no scarcity of them in
economy. However if there is a situation of scarcity in the economy, then the consumption
expenditure would automatically be reduced, irrespective of the rate of MPC.

As a result, the multiplier also reduces. On the contrary, if consumption expenditure keeps on
increasing, it would result in inflation, while there would be no increase in the real income.

(d) Not Applicable under the condition of full employment:

Implies that the theory of multiplier does not work in the situation of full employment. This is
because in case of full employment there is no scope of producing additional goods and
services and generating additional real income.