Chapter 2

CHAPTER 2
CIRCULAR FLOWS OF INCOME
Copyright © Dr. Nurul Nadia Abd Aziz 1

Syllabus
• 2.1 Concepts in national income
• 2.2 Circular flow of income in a 2, 3, and 4-sector economy
• 2.3 Three approaches of measuring national income:
– 2.3.1 Income approach
– 2.3.2 Expenditure approach
– 2.3.3 Output approach
• 2.4 Concepts and measuring personal income, disposable
income, per capita income, nominal and real income
• 2.5 Uses of national income statistic
• 2.6 Problems in measuring national income Mr. John

Definition
National Income is the total payments received by

the factors of production in a country during a year.
National income accounting calculates the total value

of goods and services produced in a country within a
particular year

Definition
Gross Domestic Product (GDP) refers to the

market value of all final goods and services
produced in a nation, in a certain period of
time.

Definition
Gross National Product (GNP) refers to the market value of

all final goods and services produced by nation’s residents,
no matter where there are located.

The Circular Flow of Income and
Expenditure
• Circular flow is the diagram showing the income received and payment made by
each sector of the economy or shows the flow of money round the economy.
– Income received/the flow of earning is the total income receive by resources
supplier (land , labor, capital, entrepreneur).
– Payment/the flow expenditure is total spending of consumers, businesses and
government on final goods and services during any given time period.

Two Sector Economy
Assumptions:
1. The economy consist of just 2 kind of economic agents-
households and firms
2. Households own all factors of production and spend all income
by buying all final goods
3. Firms hire factors of production from households, sell goods and
pay any profit made to households

Circular Flow of Income in a
2-Sector Economy
Factor of production: Land, Labor, Capital, Entrepreneur
Income (Y): Rental, Wages & Salary, Interest, Profit
HOUSEHOLDS FIRMS
Consumer Expenditure (C)
Goods and Services

To make the assumption more realistic, we assume that household
do not spend all income. In other words, household will have a
saving.

2-Sector Economy
HOUSEHOLDS FIRMS
Saving (S) Financial Investment (I)

Institutions
Goods and Services

Thus; Income = Expenditure + Saving
Y=C+ S
Saving in the bank will use as investment, thus;
Y=C+I
From the above equation we can say that:
I = S or Injection = Leakages
So in two sector economy, equilibrium of income obtain from following equation;
Y=C+I

Three Sector Economy
• In 3 sector, the economy consist 3 kind of economic agents.
– Households
– Firms
– Government
• The government undertakes three macroeconomic activities in the economy. They

are:
– Purchase goods/services from firms
– Payment of benefit and subsidies to firms and households
– Collect taxes from households and firms

3-Sector Economy
Taxes (T) Taxes (T)

GOV’T FIRMS
HOUSEHOLDS
Government Government
Spending (G) Spending (G)
Saving (S) Financial Investment (I)

Institutions
Goods and Services

• Government expenditure are injection into flow since the government
makes expenditure on goods/services and transfer payment to recipients
through welfare program. Taxation represents leakage because money
goes out of circular flow.
• Therefore in 3 sector economy, equilibrium of income equals to:

Y = C + I + G or
S+T=I+G

Four Sector Economy
• In 4 sector economy consists 4 kind of economics agents;
– Households
– Firms
– Government
– Foreign sector
• With foreign sector we have import (M) and export (X)

• Export is injection because money flow into circular flow (revenue)
• Import is leakage because money flow out from the circular flow
(expenditure)
• Therefore in 4 sector economy, equilibrium of income equals to:

Y = C + I + G + (X-M)
S + T ©+Dr.MNurul
Copyright = INadia
+ GAbd
+ XAziz 15
4-Sector Economy
Export (X)
Taxes (T) Taxes (T) Export (X)

FOREIGN
HOUSEHOLDS GOV’T FIRMS
SECTOR
Government Government Import (M)
Spending (G) Spending (G)
Financial
Saving (S) Institution Investment (I)
Goods and Services

Import (M)
16
Formula
ECONOMICS AS=AD APPROACH LEAKAGE = INJECTION

SECTORS APPROACH
1 SECTOR Y=C S=0
2 SECTOR Y=C+I S=I
3 SECTOR Y=C+I+G S+T=I+G
4 SECTOR Y = C + I + G + (X-M) S+T+M=I+G+X

Ego = 1
Knowledge
“More the Knowledge

Lesser the Ego,
Lesser the Knowledge
More the Ego…
-Albert Einstein
CHAPTER 2
NATIONAL INCOME
APPROACHES

National Income Approaches
There are three approaches to calculate national income:

1. Expenditure approach
2. Income approach
3. Output/product approach

Expenditure Approach
Expenditure approach is the method of computing by adding all
the spending for final goods and services during a period of time.
The components of spending are:
1. Personal Consumption Expenditure(C)

• The term covers all expenditures by household on durable and
non-durable goods and consumer expenditures for services
(lawyers, doctors, mechanics, barbers etc). We use the symbol
of C to signify this component.

2. Gross Private Domestic Investment (I)
• Under the heading Gross Private Domestic Investment, we include
the following items:
– All final purchases of machinery, equipment and tools by business
enterprise.
– All construction includes residential construction, new factories, and
stores. (Residential houses treat as investment because they could be
rented to bring an income return)
– Change in inventories/stocks is unsold goods, so we considered as
‘unconsumed output’ . The value could positive (increase) and negative
(decrease) over some period of time.

3. Government purchases/Consumption Expenditures(G)
• Government purchases (federal, state, local) include all
government expenditure on final goods and direct purchases of
resources, including labor. These expenditure we can divide into
two components:
– Expenditure for goods and services that government consumes in providing
public services.
– Government investment addition to its stock of capital, such as schools,
highways, bridges and government buildings.

4. Net export (x-m)
• This represents to any excess of expenditure on export over
import. Export is total spending by foreigners on domestically
produced goods and services. Import is total spending by
domestic residents on foreign produced goods and services.
Net export = total export (x) – total import (m)

Output Approach
• Output approach measure the total value of all final goods

and services produced plus any additional stock during the
year
• or total up the value added of all goods and services at each
stage of producing
• or method that computing GDP that measure the
contribution that each industry/sector makes to GDP.

Output Approach
• Value added is the difference between the value of

goods as they leave a stage of production and the cost
of the goods as they entered that stage.
• Final goods – goods or services produced to use by final
user such as car, shirt.
• Intermediate goods- goods that are produced by one
firm for use in further processing by another firm such
as tyre, cotton.

Output Approach
Primary sector – agricultural, forestry, mining, fishing,

quarrying.
Secondary sector- manufacturing and construction
Tertiary sector – services: transportation,

communication, government services, electricity, gas
and water, banking, restaurant, wholesale and retail
trade, insurance etc.

Primary Sector

Secondary Sector

Tertiary Sector

Formula
GDPmp GNPmp GNPfc NNPfc / NI PI DI
(+) Net FIFA (+) Subsidies (+) TP (-) personal

(-) depreciation
(-) Indirect tax (+) Dividend income tax
(+) Factor Income (-) EPF
Received from Abroad (-) SOCSO
(-) Factor Income Paid to (-) Insurance
Abroad (-) Un/d profit
(-) Corporate tax

GDP vs GNP
• The Gross Domestic Product figure only includes whatever output

produced in our country.
• Gross National Product is the total up all the output produced by all
economic agents include our economic factors at overseas (produced
by our economic agents at other countries).
• So we need to add these ‘property income from abroad’ into our
calculation to get Gross National Product.
• Note that Gross Domestic Product has already included the output
produced by foreign economic agents who are operating in our
country, so we should deduct these ‘property payment to abroad’.

Market Price vs Factor Cost
• Factor cost is the actual value of output when they were produced.
• Market price is the price where the consumer have to pay.
• The market price differ from the factor cost due to indirect taxes
and subsidies.
• The tax made the market price higher than the factor cost and
therefore, we need to deduct the taxes from the market price.
• On the other hand, subsidies granted to the firm will reduce the
market price lower than the goods’ actual incurred.
• So to adjust market price to factor cost we must plus subsidies and
minus indirect taxes.

Gross vs Net
• Depreciation tend to occur during the production process.
• The machinery and other capital assets are likely to go through
the course of wear and tear.
• This also known as ‘capital consumption’ or ‘disinvestment’.
• Therefore, we must exclude the provision for depreciation in
order to make sure that only the ‘net investment’ is included in
the national product.

National Income vs Personal Income
• The National Income refer to the total income received by all

economic agents, whereas the personal income represents the
total income actually received by all people in the economy
whether they are economic agents or not.
• The personal income differ from National Income due to:

• a. Some payments to factors does not actually received by the

individuals but they are included in National Income such as
1. Undistributed profit,
2. Taxes on companies profit/business/corporate taxes,
3. Employment Provident Fund (EPF),
4. Premium insurance,
5. Social Security Contribution (SOCSO).
• These items we have to deduct to find the actual income
received by individuals.

• b. Some income will received by the individuals but not included

in the National Income data such as transfer payments and
dividends.
• Therefore, these item we have to add in order to find the total
value of actual income received by individuals.
• Personal/individuals’ income = National income + transfer

payment – undistributed profit /retained earning– taxes on
companies’ profit – EPF – Socso – Insurance premium

Disposable income
Disposable income is the actual amount of income that can be

spent by individuals after pay personal income taxes/direct
taxes.
Disposable income = Personal income – income/direct taxes

National income per capita
• National income per capita is the average income per head

of population.
• To measure standard of living:
• Per Capita Income = National Income (Nominal)

Total Population

Concepts of Nominal vs Real GDP
• Nominal GDP/ GNP

– Is the market value of all final goods/services produced in a
given year valued at current prices.
• Real GDP/GNP
– Is the market value of all final goods/services produced in a
given year valued at constant prices.
Real GNP = CPI based year x Nominal GNP year 1

CPI year 1
Eco. Growth = Real GNP year 1 – Real GNP year 0 x 100

Real GNP year 0 40
How to Calculate Real GDP?
• Real GNP = Price Index year 0 x nominal GNP year 1

Price index year 1
Suppose price index year 1 = 105 and base year (year 0) = 100,
And nominal GNP = 25,000:
Real GNP = 100 x 25,000 = 23,810

105

• E.G = Real GNP year 1 - Real GNP year 0 x 100
Real GNP year 0
• Real GNP year 1= real GNP at current year

• Real GNP year 0= real GNP for the base year
E.G = 24,113 - 22,340 x 100

22,340
= 7.94%

Example
2006 2011
Quantity of Goods 5000 5000

& Services
Price RM1.00 RM1.20
CPI 100 120
Nominal NI 5000 x RM1.00 = RM5000 5000 x RM1.20 = RM6000
Real NI 100/100 x 5000 = RM5000 100/120 x 6000 = RM5000

Explain Any Four (4) Uses Of
Calculating National Income 4. To identify the
1. To measure the rate contribution of
of Economic growth of various sector
the country
2. To measure the 5. Assist the

standard of living of government in
a country its Economics
Planning
3. To compare the wealth

of different countries / 6. Comparison
comparisons between over time
countries
1. To measure the rate of economic
growth of the country
• To measure the rate of growth of the country in a
country’s economic activities from one year to
another.
• To calculate the rate of economic growth, we need
to calculate the real GNP/GDP using national
income.

2. To measure the standard of living
of a country
• The national income is commonly measured in terms of
income per capita of a country.
• In general the higher is the income per capita, the
higher standard of living will be.
• Example; countries with national income higher such as
USA, UK, Canada, Japan also have high standard of
living.

3. To compare the wealth of different
countries/comparisons between countries
• The national income figures can be used to compare the

wealth and standard of living for different countries.
• Also through the national income we can differentiate
between develop and developing countries.
• If the national income of one country is higher then
another country, we may conclude that the country with
a higher income is wealthier than the other country.

4. To Identify the contribution of
various sector
• There are 3 main sectors in the economy-primary, secondary and tertiary sector.
• By analyzing the contribution of each sector we will be able to know which sector
makes the most contribution to the country’s economic growth.

5. Assist the government in its
Economics Planning
• National income estimates, help the government in
formulating their economic policies.
• Therefore the national income figures can assist the
government in designing future economic planning.
• Forecasting future development is made easier when
national income estimates are collected

6. Comparison over time
• From national income figures, we are able to state whether

the economy is progressing or not.
• If national income increases over the years, we can safely say
that the economy is growing.

Explain Any Four (4) Problems In
4. Problem of
Calculating National Income
inaccessibility
5. Problem of
3. Lack of
false information
sophisticated
machinery
6. Arbitrary
2. Problem of definition
expertise
7. Problem of
1. Problem of double counting
illiteracy
1. Problem of Illiteracy
• This is especially so in most third world countries like India, Bangladesh, Indonesia,
Myanmar.
• The governments of these countries will face difficulties in getting information such
as estimated value of home-produced goods.
• The people fail to appreciate the significance of data collection of the national
income.
An increase in GNP does not necessarily reflect an increase in the standard of living
and economic welfare of a country.
Discuss the above statement.

2. Problem of Expertise
• The shortage of professionals in
most developing countries is a major
problem.
• To estimate national income
accurately, the services from
statisticians, analysts, programmers,
researchers are dire in need.
• These professionals will be able to
present the national income data
with the minimum technical and
human errors.

3. Lack of sophisticated machinery
• This makes analyzing of data difficult - technical equipment.
• Poor countries face with this problem, they need the latest and most advanced
computers to compute the massive volume of data.
• With the obsolete machinery that there are presently utilizing, the data become
questionable.

4. Problem of Inaccessibility
• There are certain areas especially poor countries that are remote and isolated.
• Though there are not totally inaccessible, yet, in term of cost they are expensive to
survey.
• So without such data, national income will not be accurate.

The number of islands in Indonesia, according to data from the Ministry of Interior of
the Republic of Indonesia in 2004 are 17,504 units. 7,870 of them have names, while
9634 do not yet have a name. Among the many islands in Indonesia, only about
6,000 are inhabited islands.

5. Problem of False Information
• This problem prevails in all countries but it is more serious in the
developed countries.
• Businessmen and other self-employed people usually
underestimates their earnings primarily to evade paying high
taxes.

6. Arbitrary Definition
• The problem here is whether to include or exclude certain items

in national income accounting.
• For example, the services of housewives are not included but the
same services, housekeeping done by maid are included.
• Goods which have a serviceable life of several years are included
in the national income at their full value only in the year they are
bought.
• Government services which are not paid for (eg: police services,
education, etc. ) are included in the national output at cost.

7. Problem of double counting
• Double counting of goods and services will exaggerate
the value of GNP.
• All goods and services produced in any given year must
be counted once, but most products go through a series
of production process before reaching the market.
• As a result, parts and components of a product are
sold/bought many times which involves repeated
calculations.
• Hence to avoid these calculation, GNP should include
only the market value of final good and ignores those
involving intermediate goods
Question
An increase in GNP does not necessarily reflect an

increase in the standard of living and economic welfare
of a country.
Discuss the above statement.

4. Quality of goods and
services
3. Composition of goods
and services 5. Facilities available
2. Income distribution 6. Government

expenditure
1. General Price Level

7. Population

1. General Price Level
• The increase in national income could be due to the general
price level (the rate of inflation).
• This definitely does not reflect the actual increase in physical
goods and services in the country.
• Example; when the general price level rises by 50 percent and
the output remain constant, the national income will increase
by 50 percent.
• However the amount of goods and services has remained
unchanged.
• So to find the actual GDP/GNP we have to deflate the general
price level of the current year.

2. Income Distribution
• Even though national income may have
increased, the increase may only enjoyed by
certain people/group in the society.
• So the standard of living for common people
has not improved.

3. Composition of Goods and Services
• If the country produces more machinery and factories than consumer goods and
services, then the standard of living has not increased.
• When we refer to the welfare of the consumers, obviously, the types of goods are
for their own consumption.

4. Quality of Goods and Services
• In addition to the quantity of goods and
services, the quality must also be
maintained if not upgraded. www.kosmo.com.my
www.utusan.com.my Copyright © Dr. Nurul Nadia Abd Aziz 65

Examples
syurgafirdausy.blogspot.com
www.azmitakaful.com
5. Facilities Available
• It is not always true that when a country has
higher national income, the facilities would also
improve such as medical, housing, educational
and recreational facilities.

6. Government Expenditure
• Example Russia and India, over the year their national income has increased but
we cannot conclude that Russian and Indians standard of living has improved
because the governments is spending more on military, space and nuclear
research.

7. Population
• The increase in national income may be absorbed

by the increase in population as is the case in
India, China and Indonesia.
• Total population
• Malaysia = 31,700,000 (update: July 2017)
• Indonesia = 237,641,326  Jakarta = 8,792,000
(740 km²)
• Singapore = 5,399,200
• Brunei = 393,162


Chapter 2 - National Income

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CIRCULAR FLOWS OF INCOME

Copyright © Dr. Nurul Nadia Abd Aziz 1

Copyright © Dr. Nurul Nadia Abd Aziz 2

National Income is the total payments received by

National income accounting calculates the total value

Copyright © Dr. Nurul Nadia Abd Aziz 3

Gross Domestic Product (GDP) refers to the

Copyright © Dr. Nurul Nadia Abd Aziz 4

Gross National Product (GNP) refers to the market value of

Copyright © Dr. Nurul Nadia Abd Aziz 5

Copyright © Dr. Nurul Nadia Abd Aziz 6

Copyright © Dr. Nurul Nadia Abd Aziz 7

Income (Y): Rental, Wages & Salary, Interest, Profit

Consumer Expenditure (C)

Goods and Services

Copyright © Dr. Nurul Nadia Abd Aziz 8

Copyright © Dr. Nurul Nadia Abd Aziz 9

Income (Y): Rental, Wages & Salary, Interest, Profit

Saving (S) Financial Investment (I)

Goods and Services

Copyright © Dr. Nurul Nadia Abd Aziz 10

Copyright © Dr. Nurul Nadia Abd Aziz 11

• The government undertakes three macroeconomic activities in the economy. They

Copyright © Dr. Nurul Nadia Abd Aziz 12

Income (Y): Rental, Wages & Salary, Interest, Profit

Taxes (T) Taxes (T)

Saving (S) Financial Investment (I)

Goods and Services

Copyright © Dr. Nurul Nadia Abd Aziz 13

• Therefore in 3 sector economy, equilibrium of income equals to:

Copyright © Dr. Nurul Nadia Abd Aziz 14

• With foreign sector we have import (M) and export (X)

• Therefore in 4 sector economy, equilibrium of income equals to:

Income (Y): Rental, Wages & Salary, Interest, Profit

Taxes (T) Taxes (T) Export (X)

Consumer Expenditure (C)

Goods and Services

ECONOMICS AS=AD APPROACH LEAKAGE = INJECTION

1 SECTOR Y=C S=0

2 SECTOR Y=C+I S=I

3 SECTOR Y=C+I+G S+T=I+G

4 SECTOR Y = C + I + G + (X-M) S+T+M=I+G+X

Copyright © Dr. Nurul Nadia Abd Aziz 17

“More the Knowledge

Copyright © Dr. Nurul Nadia Abd Aziz 19

There are three approaches to calculate national income:

Copyright © Dr. Nurul Nadia Abd Aziz 20

The components of spending are:

1. Personal Consumption Expenditure(C)

Copyright © Dr. Nurul Nadia Abd Aziz 21

Copyright © Dr. Nurul Nadia Abd Aziz 22

Copyright © Dr. Nurul Nadia Abd Aziz 23

Copyright © Dr. Nurul Nadia Abd Aziz 24

• Output approach measure the total value of all final goods

Copyright © Dr. Nurul Nadia Abd Aziz 25

• Value added is the difference between the value of

Copyright © Dr. Nurul Nadia Abd Aziz 26

Primary sector – agricultural, forestry, mining, fishing,

Secondary sector- manufacturing and construction

Tertiary sector – services: transportation,

Copyright © Dr. Nurul Nadia Abd Aziz 27

Copyright © Dr. Nurul Nadia Abd Aziz 28