Unit 2- Circular Flow of Income and National Income Accounting

 Meaning of National Income

 Importance of National Income

 Circular flow of NI- Two sector economy

 What is National Income

• National Income “National income measures the total value of goods

& services produced within the economy during the course of a year”
• “The labour & capital of a country acting upon it’s natural resources
produces annually a certain amount of net aggregate of commodities,
material and immaterial including services of all kinds” - Prof.
Marshall
• From this it is inferred that NI is the market value of all final goods
and services produced in the economy in a year.
• It measures market value of annual product.
• National Income is a monetary measure.
• Two things must be noted with regard to NI.
• 1. It measures the market value of annual output because it is a
monetary value.
• 2. In order to measure to NI accurately all goods and services
produced in a given year must be counted only for once and not
more than once.
• This is because;
• Most of the goods go through a series of production stages before
reaching a market. As a result parts or components of many goods are
bought and sold many times.
• Hence, in order to avoid counting many times the part of goods sold
and resold, NI includes only market value of all final goods and ignores
the transactions involving intermediate goods.
• Concept of NI has three interpretations:
• It represents total value of production, which includes both Receipts
and Payments in total.
• That is amount spent is equal to amount received.
• If goods and services are valued at their market prices, then we have
Three fold identity.
• The value received is equal to the value paid equals the value of
goods and services produced and sold.
• National Income = National product = National Expenditure
 Circular flow of Income
• This is better understood with a Two Sector Economy.
• Households
• Firms
• Firms require to produce goods
• For production we require factors of production like, Land, Labour,
Capital and Entrepreneurship which are hired and paid rewards for
their contribution to the production of goods. (Income arises due to
production)
• The sales value of net production must equal to the sum of total of
payments made by the firms to the factors of production in the
course of production.
Circular flow of income in a simple Two Sector Economy
• In the upper loop of the fig, resources such as land, capital and
entrepreneurial ability flow from HHs to business firms as indicated by
the arrow mark.
• In the opposite direction, money flows from business firms to the HHs
as factor payments such as wages, rent, interest and profits.
• In the lower part of the figure money flows from HHs to firms as
consumption expenditure made by the HHs on the goods and
services produced by the firms, while the flow of goods and services
is in the opposite direction from business firms to HHs
• It is like money flows from business firms to HHs as factor payments
and then it flows from HHs to firms.
• Thus there is a circular flow of money or income.
• It is an indefinite flow week after week followed year after year.
• Thereby income flows from the firms to the households in exchange of
productive services.
• Income again returns to the firms when expenditure is made by HHs, on
goods produced by the firms.
• Thus NI is
• National Income= National Product = National Expenditure.

NI is sum of all final goods and services

NI is sum of all incomes in cash and kind accruing to factors of
production in a year.
NI is sum of all consumption expenditure, net investment
expenditure, and government expenditure on goods and services
 Circular flow of Income cont…

1. It is a model of the economy that shows the flow of incomes (and

expenditures) that result from choices of the economic agents.
2.Simple two sector model/purely private economy
Business Sector: Hires factors of production, Produces goods and
services
 Households Sector: Supply resource services, Purchase goods and
services produced by firms
1.FACTOR & PRODUCT MARKETS :
The factor market is where the services of resource suppliers are bought
and sold.
 The product market is the place where goods and services produced by
firms are bought and sold.
1. In the product market: Businesses use the factors of production
purchased to produce goods and services.
2.Consumers spend money on the goods and services.
• REAL & MONEY FLOWS
• Real flows are: Flows of resources that go from households
through factor markets to firms
• The goods and services that go from firms through product
markets to households. (Physical Goods)
• Money flows are: The flows of payments made in exchange
for the services of factors of production, expenditures on goods
and services.
 • However, the flow of income is always not the same Why?

• It will not continue at a constant level.

• In a year of depression the circular flow of money income will
contract, will become lesser and lesser in Volume.
• This is because the flow of money is a measure of National
Income and will therefore change with changes in National
Income.
• In the year of Depression when NI is low, the volume of flow of
money will be small and in years of prosperity when level of
income is quite high, the flow of money will be large.
• This type of circular flow is simple with central issues, the flow of money
occurs in a closed economy, as we have ignored:
Savings
Profits (Investment)
 Role of Government ( Taxes, Spending and Borrowing)
International Trade (Imports & Exports)
• but in reality all the above elements are active.
• If we consider Savings and Investment ,savings reduce the flow of money
expenditure to the business firms and will cause a fall in economy’s total
income.
• Economists call savings is a leakage from the money expenditure flows.
• Thereby the government intervention is needed to make the economy to be
on the path of Steady line.
A more simple two sector model
 Three sector model

1.GOVERNMENT ACTIVITY : Represent the impact of including government into

the circular flow of income.
2. Flows (5) through (8) illustrate that government makes purchases in both product
and resource markets.
3. Flows (5) and (6) represent government purchases of such products as paper,
computers and military hardware from private businesses.
4. Flows (7) and (8) represent government purchases of resources, government
employs and pays salaries to civil servants. Government then provides public goods
and services to both households and businesses as shown by flows (9) and (10).
To finance those public goods and services, businesses and households pay taxes
and this is shown by flows (11) and (12). Solid Waste Tax could increase revenue
Government changes up the circular flow.
Reallocates resources
Stabilizes the economy
Changes the distribution of income
The modern monetary economy comprises a network of four sector economy these
are:
1. Household sector
2. Firms or Producing sector
3. Government sector
4. Financial sector.
Each of the above sectors receives some payments from the other in lieu of goods
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and services which makes a regular flow of goods and physical services.
Money facilitates such an exchange smoothly.
• Financial institutions role it is to accept and protect the savings of consumers and to
make investment funds available to producers.
Five sector model • In the five sector model the economy is divided into five sectors:
1. Household sector 2. Firms or Producing sector 3. Financial sector : 4. Government
sector 5. Rest of the world sector: transforms the model from a closed economy to
an open economy.
 Money flows in the Five sector open economy
• In a four sector economy money flows generated in an open
economy, that is having trade relations with foreign countries.
• The inclusion of Foreign sector will reveal the interaction of
domestic economy with foreign economies.
• Foreigners interact with the domestic firms and HHs through
exports and imports of goods and services as well as through
borrowing and lending operations through financial markets.
• What are Imports: Purchase of foreign made goods and
services by domestic HHs
• Exports are those goods and services which are produced
domestically and purchased by foreign countries.
• We are considering the business firms of domestic economy that interact with
foreign countries and therefore export and import of goods and services.
• If exports are equal to imports it is considered as balance of Trade.
• If the value of exports exceeds the value of imports it is considered as “Trade
Surplus”
• On the contrary if the value of exports are less than imports it is referred as
“Deficit Trade”.
• The volume of exports in an economy depends of
• The prices of exports in any domestic economy relative to the price in the other
countries.
• Income level in the other countries.
• Tastes ,Preferences, customs and traditions in other countries.
• Tariff and trade policies in both the countries.
• The domestic economy’s level of imports.
• 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 referred as financial market.
• Presently financial markets around the world are well integrated
• If there is export surplus (X>M) net capital out flow will take place.
(Means foreigners will borrow from domestic savers to finance for
their purchases of our exports, thereby domestic savers will lend to
foreigners to acquire foreign financial assets.)
• If there is Import deficit importers are more than exporters, in such
a case domestic consumer HHs and business firms will borrow
from abroad to finance their excess of imports over exports, then
there will be capital inflow in our economy. As a result, foreigners
will acquire domestic financial assets.
 Leakage and Injection
•  Leakage means withdrawal from the flow of Income.
• When households and firms save part of their incomes it
constitutes leakage.
• They may be in form of savings, tax payments, and imports.
Leakages reduce the flow of income.
• Injection means introduction of income into the flow. When
households and firms borrow the savings, they constitute
injections.
• Injections increase the flow of income.
• Injections can take the forms of investment, government
spending and exports.
• The state of equilibrium
• In terms of the five sector circular flow of income model the state of
equilibrium occurs when the total leakages are equal to the total injections
that occur in the economy.
• This can be shown as:
Savings + Taxes + Imports = Investment + Government Spending + Exports
S+T+M≠I+G+X
 If the state of the sum of total leakages does not equal the sum of total
injections it will result in disequilibrium.
Disequilibrium can be shown as:
Savings + Taxes + Imports ≠ Investment + Government Spending + Exports
S+T+M≠I+G+X
 Saving and Investment identity in an open economy
• From the circular flow it is noticed that in an open economy that National Income
must be measured by aggregate expenditure that includes net of exports, that is X-M
where X represents exports and M represents imports.
• Imports must be subtracted from the total expenditure made by foreigners on our
domestically produced goods and services exported to them to get the value of the
net exports. Thus in an open economy,
NI = C+I+G+NX
Where NX represents net exports, X – M
Since NI can be either consumed, saved or paid as taxes to the government we
have
C+I+G+NX = C+S+T
Since ‘C’ is common on both sides we have
I+G+NX = S+T
It shows that in the open economy the sum of private investment (I),government
expenditure(G) and net exports (NX) is equal to the sum of savings and tax revenue.
 Relation of Aggregate domestic output and expenditure with Trade Balance

• The National income account identity of an open economy is used

to show how aggregate domestic output (Y) and aggregate
expenditure (C+I+G) and net exports are related.
• By arranging the NI in an open economy (Y = C+I+G+NX)
• NX = Y – (C+I+G), where (C+I+G)is aggregate domestic
expenditure.
• Thus,
Net exports = National Domestic Product (Y)- Aggregate Domestic expenditure
From this it follows that in an open economy aggregate domestic expenditure need not be
equal to the aggregate domestic output of goods and services (Y).
If Aggregate domestic output (Y) exceeds aggregate domestic expenditure (C+I+G) we
export the excess of domestic output that is net exports are positive, (Nx>0).
On the other hand, if domestic output is less than domestic expenditure we import this
short fall(NX< 0)
 Foreign capital flows and Trade Balance
• Similar to a closed economy goods market is also closely related to the
financial market in an open economy.
• National income identity in an open economy is
Y = C+I+G+NX by rearranging the terms
Y-C-G = I + NX
The left hand side of the equation (Y-C-G) represents National savings(S).
Note all government expenditure is treated as consumption expenditure.
So it follows
S = I + NX
or
S – I = NX
The national income identity of expression shows that the economy’s net
exports (NX) must always be equal to the difference between saving and
investment.
The net exports are also called trade balance because it shows the difference
between exports and import of an economy.
The trade balance (NX) may be positive or negative. If exports exceeds
imports trade balance (NX) is positive and if exports fall short of imports,
the trade balance (NX) is negative.
Thus, it follows from the national income identity of an open economy
relates to the link b/n International Capital flows and the goods market.
If S – I is positive the economy’s national savings exceeds domestic
investment, it will be lending excess funds to foreigners, there will be net
capital outflow from the economy.
On the other hand, if S–I is negative the domestic investment exceeds
domestic savings, the economy will be borrowing from abroad to finance
the excess investment. There will be net capital inflow in to the economy
to finance higher capital formation in the economy.
Thus net capital flows (S–I)always equal the trade balance or to current
account balance which is the broader term that includes invisibles.
 National Income & National Product
• Sum of all incomes of the people of a country is called National Income which
is greatly related to national product.
• In a two sector economy without government and its imposition of indirect
taxes and grant of subsidies and also assuming no depreciation national
income and national product are one and the same.
• National income is the incomes earned by all factors in the form of wages,
rent, Interest and profit as the rewards for factors.
• Various HHs obtain their income from the productive firm which utilize their
labour land capital and other services for the production of goods and
services. The incomes earned are the costs of production of the goods
produced.
• The total value of all final goods and services produced by various
productive businesses in a year is known as national product. Thus national
product of a country is estimated by multiplying the total output of final
goods and services with their market prices.
• Thus, the National Product in value terms produced by various
productive factors is distributed among those who contributed
to its production by giving them in the form of incomes.
• So the national product (value of total output of final goods and
services in a year of a country) is distributed among the factor
rewards.
• From all these counts we say that National product will be equal
to National income.(In a two-sector economy without
government and foreign trade national Income is equal to
national product)which is presented below.
• On these lines Prof. J.R Hicks gives the definition for NI are the
sum of the incomes “The value of the net social product of the
community and the sum of the incomes of its members are
exactly equal. The net social product and the social income
are one and the same thing.
• Note: National product is equal to National income is valid only in
simple two sector economy.
• In reality firms keep a part of some value created as depreciation
allowance, which cannot be part of income of the factors of
production also there is greater role of government in the form of
taxes and subsidies.
• This results in to growth of NI is achieved by increase in production
of goods and services.
 Concepts of National Income: GNP, GDP,NNP, NDP, PCI

• GNP: Gross National Product is defined as the total market

value of all final goods and services produced in a year in a
country.
• Two things must be kept in mind,
• GNP is the monetary measure. There is no other way of
adding up the different sorts of goods and services produced in
a year except in terms of their money prices.
• All goods and services produced in a year must be counted
once, because most of the goods go through a series of
production stages before reaching a market. As a result goods
are sold many times. To avoid counting several times consider
the final market value of a good.
 Final & Intermediate goods

• What are final goods, those which are purchased for final use and
not resale.
• Intermediate goods are those which enters in to further
processing for future use. Or Goods which are further used in
production process are called intermediate goods.
• NI is a flow of measure of output of goods and services per time
period.
• In market transactions involving sale & Purchase of old
properties, sale of assets such as stocks, bonds are not included
in estimating NI.
• GNP refers to the value of goods and services currently produced
by normal residents of a country where ever they are working.
 The components of GNP

• Value of final consumer goods and services produced in a year

and consumed by households and is denoted as C.
• Value of new capital goods produced and addition to the
inventories of goods such as raw materials, unfinished goods
and consumer goods produced but not sold during a year. This
is known as Gross Private Investment.
• Value of output of general government which is taken to be
equal to the value of purchases of goods and services by the
government and is denote as Private Investment.
• Net exports which is equal to value of goods exported minus
the value of imported.
• Gross Domestic product: GDP is the money value of all final
goods and services produced by normal residents as well as non
residents in the domestic territory of a country but does not
include net factor income earned from abroad.
• Gross Domestic Product is expressed as
GDP MP = GNPMP – net factor income from abroad

Or

GDP MP = GNPMP + net factor income from abroad

GDP = C+I+G+X-M

Note: Factor income should not be confused with income from net
exports.
Various concepts of National Product
 NNP or National Income at market prices
• The second important concept of NI is NNP.
• In the production of GNP fixed inputs like machinery, equipment etc are
repeatedly used and they need repair and maintenance.
• NNP at market prices: NNP is obtained by subtracting Depreciation value from
GNP i.e, market value of final goods and services after providing for depreciation.
• Net National product or National income at market prices NNP =
GNP – Depreciation allowance.
• Why should we account the depreciation, because while estimating GNP no
provision is made for depreciation allowance, in such a situation GNP will not
reveal complete flow of goods and services through various sectors.
• A part of this, therefore set aside in the form of depreciation allowance. By
subtracting depreciation allowance from GNP we get net national product also
called NNP at market prices,
•  since the value of all goods and services is taken at the market prices.
 National income at factor cost or National Income
• NI at factor cost is the sum of all incomes earned by resource
suppliers for their contribution of Land, Labour, capital and
entrepreneurial ability
NI = NNP(At market prices) – Indirect taxes + Subsidies.
NI shows how much it costs society in terms of economic
resources to produce net output.
It is really the national income at factor cost for which we use the
term national income.
The difference between national income and net national product
arises from the fact that indirect taxes and subsidies cause
market prices of output to be different from the factor
incomes resulting from it.
• For example if the market price of a commodity is Rs.200, the value of
the commodity at factor cost will be less than its market price, i.e, say
Rs.175, then what about of Rs.25, i.e, the tax imposed by the
government there by the market price of the commodity increases,
but truly there is no physical production of goods.
• On the other hand, a Subsidy causes the market price to be less
than the factor cost.
• Suppose the factor cost of a product is Rs.100, but the market price is
reduced to Rs.10, there by the market price is Rs.90. example
handloom cloth is subsidized to the extent of Rs.100 per meter and it
will be sold at a price less than production cost.
 Personal Income PI

• Personal income is the sum of all incomes actually received by

all individuals or HHs during a given year.
• National Income, that is the incomes earned, is different
from personal income which is received.
• Total incomes received must be different because some
incomes which are earned such as Social Security
contributions , corporate income taxes and un distributed
corporate profits are not actually received by HHS, conversely
some other incomes which are received like transfer payments
are not currently earned.(old age pensions, Un employment
benefit, relief payments, interest payments and debt etc)
• Thus, in moving from NI as an indicator of income earned to
personal income as an indicator of income actually received ,
we must subtract from NI those three types of income which
are earned but not received and add those incomes which are
received but currently not earned. Therefore
Personal Income
• NI – SSC – Corporate income taxes – undistributed corporate profits+ Transfer payments
• NI = National Income
• SScs = Social Security Contributions
• Transfer Payments (Pension, Un employment doles and relief payments)
 Disposable income
• The whole of the income which we actually received by people
are not available to them for consumption.
• Because Government levy some personal taxes such as
income tax, personal property taxes.
• Therefore, after paying part of the income, what remains is
called Disposable income.
Disposable income = Personal Income - Personal taxes
Disposable income further divided as consumption plus savings.
Disposable income = Consumption + savings
• Per Capita Income :
• The average income of the people of a country in a particular year is
called Per Capita Income for that year.
• For instance, in order to find out the per capita income, the national
income
• With above one lakh USD, Luxembourg has the highest GDP
(nominal) per capita globally in 2020, which is ten times the world
GDP per capita and over 400 times of lowest-ranked South Sudan of
US$264 per annum.
• 2019,World bank National Accounts data shows that India’s Per
capita income for the year 2019 is USD 2,099.6, UK 42,330.1, USA
65,297.5, Japan 40,246.9 and German 46,445.2.
 Methods to measure National Income
• The national income of a country can be measured by three alternative
methods: (i) Value Added/Product Method (ii) Income Method, and (iii)
Expenditure Method.
• Value Added Method is also known as output method or product method.
• Under this the economy is divided in to different sectors like
Agriculture,
Mining,
Fishing,
Construction,
Manufacturing,
Trade and commerce and
Transport etc.
• The net value added at factor cost (NVA FC) by each productive enterprise as
well as by each industry or sector is estimated.
• First we have to find the values of various goods and services produced by
enterprises in the domestic territory of a country
• The quantity of goods and services produced by a particular enterprise
multiplied by their market prices is called value of output.
• By summing up the value of output of all producing enterprises in a given
industry or a sector we can obtain the value of that industry or sector.
• A majority of output is sold in the market as sales and the one is not sold is
gone in to stock of goods or inventories.
Value of an enterprise = sales + Change in stocks
• Gross value Added at market prices (GVA MP) measures the contribution to the value of output
of a product produced during a year. Value of output is estimated by multiplying the quantity of
output with the market prices.
• (GVA MP)is obtained by deducting the value of intermediate consumption.

(GVA MP) = Value of output – Intermediate consumption

Net Value Added at market prices = (GVA MP) – Depreciation

NI or NNP FC =NDP FC + Net factor income from abroad

One great advantage of this method is it reveals the relative importance of the different
sectors of the economy by showing their respective contributions to the national income.
Precautions:
Imputed rent values of self occupied houses should be included.
Sale and purchase of second hand goods should not be included.
 Income method
• This method is Distributive aspect of NI
• Under this method National Income is obtained by
summing up of the incomes of all individuals of a
country.
• Individuals by giving their services or their property for
rent or interest on capital to the national production.
• National income is obtained by adding up the rent,
wages salaries of employees, interest on capital
entrepreneurial profit and incomes earned by self
employed people.
• The advantage is that it indicates the distribution of NI
among different income groups.
• The steps involved in this method are:
1.Identify the productive enterprises and classify them in to
different sectors.
2. Classify the factor payments as
Compensation of employees includes wages, salaries,
employees contribution to SSCs
Rent, Royalty if any
Interest
Profits includes Dividends, Un distributed profits and corporate
income taxes.
Mixed incomes of the self employed
• 3. Then measure factor payments
• 4. Adding up of factor payments belonging to an individual sector.
• 5. sum up the incomes paid out by all industrial sectors we obtain
domestic factor income which is Net Domestic Product at factor cost
NDP FC
• Finally add up the net factor income earned from abroad to domestic
factor income or NDP FC
• Precautions:
• Transfer Payments are not included in Income
• Imputed rent of self occupied houses are not included in NI
• Illegal Money like hawala, smuggling are excluded
• Wind fall gains are not added in NI
• Corporate profit taxed should not be separately included as its
been included in Entrepreneurial income.
• Death duty, gift tax, wealth tax on lotteries are not included.
• Receipts from second hand goods are not added.
• Income equal to the value of production for self consumption
should be estimated and added in NI.
 Expenditure Method
• NI is arrived by adding up of all expenditures made on goods and services
during a year.
• Income is spent on either on Consumer goods or on Capital goods through
savings.
• Expenditure can be made by private individuals and HHs or by government
by business enterprises.
Final private consumption expenditure i.e, expenditure on consumer goods
and services (C).
Government final consumption expenditure on goods and services to satisfy
collective wants (G).
Gross domestic capital formation (GDCF): Expenditure by productive
enterprises on capital goods
Expenditures on imports and exports.  
GDPMP = (C+I+G)+ (X-M)
 GDPMP= C+I+G + (X-M)
By deducting consumption of fixed capital(Depreciation) from GDP at market prices
we get, Net domestic product at market prices.

• NNP FC = GDPMP – Consumption of fixed capital- Net Indirect taxes + Net factor income from
abroad

While estimating GDP through expenditure method these precautions are to be taken.
Second hand goods: Expenditure on these goods are not included.
Purchase and share of bonds: Bonds and shares are merely financial claims.
Expenditure on Transfer payments: Old age pension, Unemployment benefit are just transfer of
money but no production or service is generated.
Expenditure on intermediate goods: many commodities enter in to further production process, to
avoid double counting we need to exclude them.
 The difficulties in measuring NI are of two types

 Conceptual
 Statistical
1. Treatment of non monetary transactions
2. Treatment of government activities in NI accounts
3. Treatment of income generated by foreign firms
• Other difficulties in India.
1. Difficult in estimating non monetized transactions
2. Illiteracy
3. Incomplete occupational specialization.
4. Lack of adequate statistical data.
5. The primary and secondary sectors are still un organized.
 National Income and Economic Welfare
• GNP is used as a measure of satisfaction or economic welfare of the
people.
• The greater the magnitude of national income, the greater the level
of economic welfare.
• Economic growth of an economy is measured in terms of NI and in
per capita income.
• In fact NI is not a satisfactory measure of welfare, instead “New
Economic Welfare” (NEW) is a true measure of economic welfare as it
includes welfare of the people. To estimate NEW, certain things are
need to be included/excluded from GNP
• Under usual GNP Leisure is excluded, but by having leisure
time to value of satisfaction that people derive from leisure.
• In fact people derive satisfaction not only from goods and
services, also from leisure they have
• Under the “NEW” leisure is added, which was not considered in
GNP.
• .But,If average working hours are reduced to have leisure,
National product decreases.
 Included items
• Leisure:
• satisfaction derived from Leisure. By having leisure Productivity
reduces, there by NI. Value of satisfaction people derive from having
leisure should be added.
• Non marketed personal services: services rendered by Housewives to
their family members will add their welfare but are not recorded in NI
accounting.
• Personal services rendered for themselves ( gardening, painting etc)
adds to raise their welfare but is not get registered in national
income or GNP.
 Excluded items
Harmful effects which results from increase in output.
Eg: Air, water and sea pollution. Though industrialization increased
output but reduced the welfare of the people.
So for preparing measure of net welfare negative values ought to be
assigned to the environmental pollution that results from the
production of goods and services. (Costs of Economic Growth)
Regrettable costs: In addition to environmental pollution deductions
on account of wasteful and unproductive expenditure( Expenditure
on defence, Police and law & courts) to maintain law and order)
• To sum up National Income and New Economic Welfare is
represented as
• Real GNP – Depreciation + value of leisure + Non marketed
activities – Environmental pollution – Regrettable costs Net
Economic Welfare.
• Also Well being of the people depends upon the relative
proportions of the availability of consumer goods, Luxury goods
and capital goods.
• If a country produces large number of luxury goods than
consumer goods, the poor will be deprived of basic necessaries
____________________________________________
 Importance of National Income
• To Provide an index of an economic activity and an instrument of
economic planning.
• National income accounting indicates the growth of the economy in
terms of income and output.
• National Income statistics help the policy makers to frame policies to
achieve full employment and rapid economic growth.
• It is useful in measuring the standard of living of a nation by
estimating per capita income.
• Comparison between the countries is made possible.
• Useful in measuring income inequalities.
• In revealing the expenditure pattern of a country