1) INTRODUCTION

National Income is the total amount of goods and services produced within some
"boundary. " The boundary is usually defined by geography or citizenship, and may also
restrict the goods and services that are counted.

A variety of measures of national income and output are used in economics to estimate total
economic activity in a country or region, including gross domestic product (GDP),
gross national product (GNP), net national income (NNI), and adjusted national income
(NNI* adjusted for natural resource depletion). All of the measures are especially concerned
with counting the total amount of goods and services produced within some boundary. The
boundary is usually defined by geography or citizenship, and may also restrict the goods and
services that are counted. For instance, some measures count only goods and services that
are exchanged for money, excluding bartered goods, while other measures may attempt to
include bartered goods by imputing monetary values to them.

Arriving at a figure for the total production of goods and services in a large region like a
country entails a large amount of data-collection and calculation. Although some attempts
were made to estimate national incomes as long ago as the 17th century, the systematic
keeping of national accounts, of which these figures are a part, only began in the 1930s,
in the United States and some European countries. The impetus for that major statistical
effort was the Great Depression and the rise of Keynesian economics, which prescribed a
greater role for the government in managing an economy, and made it necessary for
governments to obtain accurate information so that their interventions into the economy
could proceed as well-informed as possible.

2) Three Different Phases of Circular Flow Indicating Three Different Methods of

Calculating National Income
As it is assumed that the flow of income is circular. The circularity of income never stops
because it is linked with the circularity of production. And circularity of production never
stops because it is linked with the circularity of consumption, which never stops.
A deeper insight into the circular flow of income reveals that this process passes through
three different phases, viz.
 1. Phase of Production,
2. Phase of Distribution of Income,
3. Phase of Expenditure of Income.

In phase 1, the producing sector is themselves engaged in the production of goods and services.
The firms purchases factors of production from the households and organize these factors to
produce goods and services. Production leads to creation of utility as raw materials are
converted
in useful things. Utility creation is also called value addition. This is measured as the difference
between the market value of output and the market value of non-factor inputs. This is equal
to the market value of final goods and services produced in the economy during the period of an
accounting year. This is what is called Domestic Product.

In phase 2, value added is distributed among those who have contributed to the process of value
addition. Logically, the entire value added is distributed among the owners of the factors of
production by the way of rent, interest, profit and compensation of employees. These are the
factor payments from the view point of the firms, and factor incomes from the viewpoint of the
households. The sum total of these factor incomes is called Domestic Income.

In phase 3 the households spend their entire income on the purchase of final goods and services.
Accordingly, domestic income is converted into the expenditure on the purchase of final goods
and services produced in an economy during a financial year. Since domestic income = domestic
product and since entire domestic income is spent on the purchase of final goods and services
produced during the year, this emerges an obvious conclusion that domestic product =domestic
income= expenditure on domestic product and is called triple identity.

The triple identity suggests that domestic or national income can be looked at from three
different angles: (i) as the sum total of all value added by producing units in the economy.

(ii) as the sum total of factor incomes generated in the economy during the period of an
accounting year.

(iii) as the sum total of expenditure on the final goods and services produced in the economy
during an accounting year.

These different angles of looking at the domestic/ national income correspond to three different
phases of the circular flow of income. Thus, the circular flow of income model suggests three
different methods of estimating domestic/national income: (i) Product method (ii) Income
method (iii) Expenditure method.

I. PRODUCT METHOD

Product method and value added method are synonyms of each other. This method measures
national income in terms of value addition by each producing enterprise in the economy during
an accounting year. The concept of value addition says that value added is the difference
between
value of output of an enterprise and the value of its intermediate consumption.
➢ Value added = Value of output – Intermediate consumption.
➢ Value of output refers to the market value of goods produced by a firm during an
accounting year. If the entire output is sold during the year, value of output
= sales.
➢ If some output remains unsold, it is added to the firm’s inventory stock. It is
expressed as change in stock during the year.
➢ Value of output = Sales + Stock
➢ Stock = Closing stock- Opening stock
➢ Intermediate consumption refers to value of non-factor inputs. Basically, it
includes the value of raw materials used in the process of production.

GDPMP = Gross value added by all the producing enterprises within the domestic territory of a
country during the period of one year.

Having estimated GDPMP, we find out the NNPFC by this way:

o NNPFC = GDPMP – Depreciation – Net Indirect taxes + Net factor income from abroad

Precautions regarding product method

Following are some important precautions regarding product method:

1) Value of sale and purchase of second hand goods is not included in value added.
Because, value of second hand goods is already accounted for during the year they were
produced.
2) Commission earned on account of the sale and purchase of second hand goods is included
in the estimation of value added. Because, commission is a reward for the service
rendered.
 3) Own account production of goods of the producing units is taken into account while
estimating value added. Because, these goods are like those produced for the market.
They are simply not sold owing to their need by the producers themselves.
4) Value of intermediate goods is not included in the estimation of value added. Because,
value of intermediate goods is reflected in the value of final goods.
5) Imputed value of production for self-consumption is taken into account. Because, these
goods are like those produced for the market. They are not sold dimply because of their
need by the producers themselves.
6) Imputed rent on the owner occupied house is also taken into account. Because, all houses
have rental value, no matter these are self-occupied or tented out.
7) Services for self-consumption are not considered while estimating value added. Simply
because, it is difficult to estimate their market value.
8) The value added in the government sector is equal to compensation of employees only. It
is because the data regarding rent and interest are not available for this sector and profit
just does not exist because all that is produced is meant for collective consumption, not
for sale in market.

II. INCOME METHOD

It is also called Distributed share method or factor payment method. Accordingly,

national income is measured in terms of factor payments to the owners of factors of
production during an accounting year.

o Factor Incomes refers to income earned by a person as a reward rendering his factor
service. It may be in the form of wage/salary for his labour, rent for his land, interest for
his capital or profit for his entrepreneurship. The factor incomes are those which are
earned, any unearned income will not be included in factor incomes.
❖ Classification of Factor incomes
➢ Compensation of Employees
▪ Wages and salaries in cash: it refers to cash paid to the employees by the employers
as a reward for the work done during the period of an accounting year.
▪ Payments in kind: it refers to benefits in kind given to the employees by the
employers.
▪ Employers’ contribution to social security: it refers to such payments as provident
fund by the employers on the behalf of the employees.
▪ Pension on Retirement: it only refers to the pension-payments as a part of the
‘Service-Contract’ between the employer and the employees.
➢ Operating Surplus: it refers to income from property and entrepreneurship.
▪ Rent
 ▪ Interest
▪ Profit
 Dividends: this part of profit is distributed among the shareholders, also called
distributed profit.
 Corporate Profit Tax: the part of profit which is paid to the government by the
way of ‘profit tax’.
 Undistributed Profit: the part of profit which is retained by the firms for future
use, also known as ‘corporate savings’ or ‘retained earnings’.
▪ Royalty
➢ Mixed Income refers to the income of the self-employed persons using their own land,
labour, capital and entrepreneurship for producing goods and services. These incomes
are a mixture of wages, rent, interest, profit, i.e. why known as mixed incomes.

The sum total of factor incomes generated within the domestic territory of a country is called
NDPFC (Net Domestic Product at Factor Cost).

o NDPFC = Compensation of Employees + Operating Surplus + Mixed Income

o NNPFC = NDPFC + Net factor income from abroad

Precautions regarding income method

Following are the precautions regarding income method:

1) Transfer earning like old age pensions, are not to be included in the national income.
Because, corresponding to transfer payments, there is no value addition in the economy.
However, retirement pensions are to be included in national income.
2) Income from illegal activities like theft and gambling etc., is not to be included in
national income.
3) Commissions paid on sale and purchase of second hand goods are to be included in
national income as these are a reward for rendering factor services.
4) Brokerage on sale/purchase of shares and bonds is to be included in national income.
Because this is a reward for factor services.
5) Income in terms of windfall gains should not be included as there is no value addition
corresponding to windfall gains. Likewise, income in the form of capital gains is not to
be treated as factor income
6) Imputed rent of owner occupied houses is to be treated along with rent as a component
of factor incomes.
7) Corresponding to production for self-consumption, there should be generation of income
in the economy. It should be taken account of.
8) Corporate tax, dividends and undistributed profits are all the components of corporate
 profits. Once profit is included in all the estimation of national income, any of these
components should not separately added.
9) Income tax is paid out of compensation of employees. It should not be separately added
in the estimation of national income.
10) Wages and salaries in cash and kind-as well as social security contribution by the
employers on the behalf of employees are all components of compensation of employees.
Any of these components should not be separately added once compensation of
employees is included in the estimation of national income.

III. EXPENDITURE METHOD

According to this method, national income is measured in the terms of expenditure on
the purchase of final goods and services produced in an economy during an accounting
year. Since final expenditure comprises of Consumption and Investment, it is also
known as
Consumption and Investment method.
❖ Classification of Final Expenditure
Final expenditure = C + I + G + (X-M)
➢ Private final consumption Expenditure refers to expenditure on final goods and
services by the individual households and non-private institutions serving society. It
includes:
▪ Consumer services.
▪ Consumer non-durable goods.
▪ Consumer durable goods.
➢ Investment Expenditure refers to expenditure on purchase of final goods by the
producers. It is further classified as under:
▪ Fixed Investment is the expenditure incurred by the producers on the purchase of
fixed assets like plants and machinery. It is often classified as (i) Business fixed
investment, (ii) Fixed investment by the households, and (iii) Public fixed
investment.
▪ Inventory Investment: it refers to the change in stock during the year.
➢ Net Exports (X-M)
Net exports refers to the difference between exports and imports during an accounting
year.
Sum total of expenditure on the domestically produced goods and services during an accounting
year is called GDPMP (Gross Domestic Product at Market Price).

o Private final consumption expenditure

+government final consumption expenditure
 +business fixed investment
+government fixed investment
+investment on residential construction
+inventory investment (= stock=closing stock-opening stock)
+net exports(X-M)
=GDPMP

(Note: Gross domestic fixed investment is also called gross domestic fixed capital formation as
investment implies capital formation or adding to the stock of the capital)

GDPMP is converted into NNPFC (national income) in terms of the following equation:

o NNPFC=GDPMP –DEPRECIATION-N.I.T+NFYA

Precautions regarding expenditure method

The following precautions are to be taken while using expenditure method;

1) Only final expenditure is to be taken into account to avoid error of double

counting. Final expenditure is to be interpreted as expenditure on the final goods and
services. Expenditure on the intermediate goods and services must be avoided.
2) Expenditure on the second hand goods is not to be included because value of second
hand goods has already taken into the account during the year of the production.
3) Expenditure on shares and bonds is not to be included in total expenditure, as these are
mere paper claims and are not related to the production of final goods and services. Such
expenditures do not cause any value addition.
4) Expenditure on transfer payment by the government is not included, because transfer
payments do not cause any value addition in the economy.
5) Imputed value of expenditure on goods produced for self-consumption should be taken
into account, as these goods are reflected in the estimation of GDP. Also, imputed rent
on owner occupied houses should be taken into account.

Factors causing increase in National Income

The prosperity of any country depends upon the large size of national income. While the size of
national income depends on the following factors:

1.) Natural resources

Natural resources are those which are God gifted like land, minerals, rivers, mountains
and climate. If any country is rich in natural resources, its national income will be greater.
So the national income volume depends upon the natural resources.
2.) Man made sources
 Roads, Canals, Buildings, Railway, factories are manmade sources and are in large
number then the size of national income will be greater.
3.) Capital
Capital is considered the life blood for the modern economy. The volume of production
depends upon the quality and quantity of capital available in the country. "Poor country
is poor because it is poor." Under developed countries per capita income is low because
there is deficiency of capital.
4.) Human resources
National income also depends upon the human resources. If natural resources are
available but a country is under populated then the size of national income will be
small. If the labour is skilled, educated and efficient then the size of national income
will be large.
5.) State of technology
If there is a lack of technology in any country, the size of national income will be small.
On the other hand, if advance technology is available in any country then its size of
national income will be large.
6.) Entrepreneurial ability
If this ability is available in large number in any country, then the size of national income
will be large. If any country is lacking this ability the size of national income will be
small.
7.) Political stability
If there is a political stability in the country, the production can be maintained at the
highest level and the size of national income will be large. The production is adversely
affected by the political unrest.
8.) Spirit of work
If the people are patriotic and they want to develop their country then they will
perform their duties honestly, and efficiently. In this way they will increase the
national income.
9.) Division of labour and specialization
If the scale of production is large then division of labour and specialization process will
start which is very useful in increasing the production of the country.

Definition of simple circular flow model

A simple circular flow model of the macro economics containing two sectors (business and
household) and two markets (product and factor) that illustrates the continuous movement of the
payments for goods and services between producers and consumers. The payment flow between
the two sectors and two markets is conveniently divided into four segments representing
consumption expenditures, gross domestic product, factor payments, and national income.
The modern economy is a monetary economy. In the modern economy, money is used as a medium
of exchange. While analyzing the circular flow of income in a two sector model of the economy,
we assume:
Assumptions of Circular Flow Model:
(i) There are only two sectors in the economy, household sector and business sector.
(ii) The business sector (or the firms) hires factors of production owned by the household
sector and it is the sole producer of goods and services in the economy.
(iii) The household sector (or the households) is the sole buyer of goods and services. It spends
its entire income on the goods and services produced by the business sector. They are also
suppliers of labor and several of other factors of production.
(iv) The business sector sells the entire output to households. It does not store. There are,
therefore, no inventories.
(v)There are no savings and investment in the economy.
(vi) The household sector receives income by selling or renting the factors of production
owned by it.
(vii) Government does, not exist for all such practical purposes (No public expenditures, no
taxes, no subsidies, no social insurance contribution, etc.).
(viii) The economy is closed one having no international trade relations.

Simple circular flow model with two-sector, two-market

According to circular flow of income in a two-sector economy, there are only two sectors of the
economy, i.e., household sector and business sector. Government does not exist at all, therefore,
there is no public expenditure, no taxes, no subsidies, no social security contribution, etc. The
economy is a closed one, having no international trade relations.

Y=C
Where Y is Income

C is Consumption

In a two-sector macro-economy, if there is saving by the household sector out of its income, the
goods of the business sector will remain unsold by the amount of savings. Production will be
reduced and so the income of the households will fall. In case the savings of the households is
loaned to the business sector for capital expansion, then the gap created in income flow will be
filled by investment. Through investment, the equilibrium level between income and output is
maintained at the original level. It is illustrated in the following figure:
The equilibrium condition for two-sector economy with saving is as follows:

Y=C+S or Y=C+I or C+S=C+I

or

S=I

Where Y is Income

C is Consumption
S is Saving

I is Investment

When saving and investment are added to the circular flow, there are two paths by which funds can
travel on their way from households to product markets. One path is direct, via consumption
expenditures. The other is indirect, via saving, financial markets, and investment.

Savings: On the average, households spend less each year than they receive in income. The portion
of household income that is not used to buy goods and services or to pay taxes is termed ‘Saving’.
Since there is no government in a two-sector economy, therefore, there are no taxes in this
economy.

The most familiar form of saving is the use of part of a household’s income to make deposits in
bank accounts or to buy stocks, bonds, or other financial instruments, rather than to buy goods and
services. However, economists take a broader view of saving.
They also consider households to be saving when they repay debts. Debt repayments are a form of
saving because they, too, are income that is not devoted to consumption or taxes.

Investment: Whereas households, on the average, spend less each year than they receive in
income, business firms, on the average, spend more each year than they receive from the sale of
their products. They do so because, in addition to paying for the productive resources they need to
carry out production at its current level, they desire to undertake investment. Investment includes
all spending that is directed toward increasing the economy’s stock of capital.

Financial Market: As we have seen, households tend to spend less each year than they receive in
income, whereas firms tend to spend more than they receive from the sale of their products. The
economy contains a special set of institutions whose function
is to channel the flow of funds from households, as savers, to firms, as borrowers. These are known
as ‘financial markets’. Financial markets are pictured in the center of the circular-flow diagram in
the above figure.

Banks are among the most familiar and important institutions found in financial markets. Banks,
together with insurance companies, pension funds, mutual funds, and certain other institutions, are
termed ‘financial intermediaries’, because their role is to gather funds from savers and channel
them to borrowers in the form of loans.

Circular Flow of Income in a Three-Sector Model:

Under three-sector model, the additional sector is the government. Two-sector economy is a
hypothetical economy, whereas the three-sector economy is much more realistic. The inclusion of
the government sector is very essential in measuring national income. The government levies taxes
on households and on business sector, purchases goods and services from business sector, and
attain factors of production from household sector.

Circular Flow of Income in a Four-Sector Model

Two-sector economy and three-sector economy are briefly discussed in previous sections. These
are hypothetical economies. In real life, only four-sector economy exists. The four-sector economy
is composed of following sectors, i.e.:
 (i) Household sector,

(ii) Business sector,

(iii) The government, and

(iv) Transaction with ‘rest of the world’ or foreign sector or external sector.

The household sector, business sector and the government sector have already been defined in the
previous sections. The foreign sector includes everyone and everything (households, businesses,
and governments) beyond the boundaries of the domestic economy. It buys exports produced by the
domestic economy and produces imports purchased by the domestic economy, which are
commonly combined into net exports (exports minus imports). The inclusion of fourth sector, i.e.,
foreign sector or transaction with ‘rest of the world’ makes the national income accounting more
purposeful and realistic. With the inclusion of this sector, the economy becomes an open economy.
The transaction with ‘rest of the world’ involves import and export of goods and services, and new
foreign investment.

Economy Leakages and Injections:

Leakages: When households engage in savings and purchase of goods and services from abroad,
we experience temporary withdrawal of funds from circulation. Therefore, leakages in the circular
flow are savings, taxes and imports

Injection: On the other hand, when we sell abroad (export) we receive income. More so when
foreigners invest in our country the level of income will also increase. These two activities are
injection into the income stream. Therefore, injections are investment, government spending and
exports.

Total Leakages = Total Injections