Circular Flow and National

Income Aggregates
● CIRCULAR FLOW OF
ECONOMIC ACTIVITY
Two sectors of the economy

•Household

•Firms
Household
● Households are consumers. They may be single-individuals or group of
consumers taking a joint decision regarding consumption.

● Their ultimate aim is to satisfy the wants of their members with their
limited budgets. Households are the owners of factors of
production—land, labour, capital and entrepreneurial ability.

● They sell the services of these factors and receive income in return in
the form of rent, wages, and interest and profit respectively.
Firms
● The term firm is used interchangeably with the term producer in
economics. The decision to manufacture goods and services is taken by
a firm.
● For this purpose, it employs factors of production and makes payments
to their owners. Just as household’s consumer goods and services to
satisfy their wants, similarly firms produce goods and services to make
a profit.

● The term ‘firm’ includes joint stock companies like DCM, TISCO etc.,
public enterprises like IOC, STC, etc., partnership concerns,
cooperative societies, and even small and big trading shops which do
not manufacture the commodities they sell.
Circular flow of income(
two sector model)
Introduction
The single most important concept in macroeconomics is the gross domestic
product (GDP), which measures the total value of goods and services
produced in a country during a year.

GDP is part of the national income and product accounts (or national accounts
), which are a body of statistics that enables policymakers to determine
whether the economy is contracting or expanding and whether a severe
recession or inflation threatens.
World GDP
Gross Domestic Product

GDP is the total market value of the final goods and services produced
within a nation during a financial year or calendar year
Real and Nominal GDP
● Real GDP is calculated in a way such that the goods and services are
evaluated at some constant set of prices (or constant prices). Since these
prices remain fixed, if the Real GDP changes we can be sure that it is the
volume of production which is undergoing changes
year Quantity Price Nominal Real GDP GDP deflator=
GDP (Nominal GDP/real GDP)*100

2015 100 10

2016 120 15

2017 150 20

2018 170 30

2019 200 40

2020 230 50
Nominal GDP
● Nominal GDP, on the other hand, is simply the value of GDP at the
current prevailing prices.
● For example, suppose a country only produces bread. In the year 2000 it
had produced 100 units of bread, price was Rs 10 per bread. GDP at
current price was Rs 1,000.
● In 2001 the same country produced 110 units of bread at price Rs 15 per
bread. Therefore nominal GDP in 2001 was Rs 1,650 (=110 × Rs 15).

● Real GDP or the year 2001 is calculated using the base year price(2000
will be called the base year) will be 110 × Rs 10 = Rs 1,100.
GDP deflator
● The GDP deflator, also called implicit price deflator, is a measure of
inflation.
● It is the ratio of Nominal GDP to Real GDP

● This ratio helps show the extent to which the increase in gross domestic
product has happened on account of higher prices rather than increase in
output.
NDPmp
● Net domestic product (NDP) equals the total final output produced within
a nation during a year, where output includes net investment, or gross
investment less depreciation:

● NDP = GDP - depreciation

Compute NDPmp
GDP= Rs.10000000 cr.
Depreciation= 12%

NDPmp= ?????????
Gross National Product

● Gross national product (GNP) is the total final output produced with inputs
owned by the residents of a country during a year.

● GNP ≡ GDP + Net factor income from abroad(NFIA)

GNP….
● Net factor income from abroad(NFIA)= Factor income earned by the
domestic factors of production employed in the rest of the world – Factor
income earned by the factors of production of the rest of the world
employed in the domestic economy
NFIA
● Net Remittances=Rs.500 cr
● Net retained earnings of firms abroad=Rs.600 cr

● NFIA=?
Net National Product (NNPmp).
● a part of the capital gets consumed during the year due to wear and tear.
This wear and tear is called depreciation.

● Naturally, depreciation does not become part of anybody’s income.

● If we deduct depreciation from GNP the measure of aggregate income

that we obtain is called Net National Product (NNP).

● Thus NNP = GNP – Depreciation

Adjustments with indirect taxes and subsidies
● all these variables are evaluated at market prices.
● Through the expression given above, we get the value of NNP evaluated
at market prices.
● But market price includes indirect taxes. When indirect taxes are
imposed on goods and services, their prices go up.
● Indirect taxes accrue to the government.
● We have to deduct them from NNP evaluated at market prices in order to
calculate that part of NNP which actually accrues to the factors of
production
Adjustments with indirect taxes and subsidies
● there may be subsidies granted by the government on the prices of some
commodities
● we need to add subsidies to the NNP evaluated at market prices.

● The measure that we obtain by doing so is called Net National Product

at factor cost or National Income.
NNP at factor cost
● NNP at factor cost =National Income (NI )

● NNP fc =NNP at market prices – Net indirect taxes

● Net indirect taxes (Net indirect taxes) = Indirect taxes – Subsidies)

Personal Income (PI).
● Let us try to find the expression for the part of NI which is received by
households

● We shall call this Personal Income (PI).

● Personal Income (PI) ≡ NI – Corporate tax - Undistributed profits – Net

interest payments made by households + Transfer payments to the
households from the government and firms.
Personal Disposable Income (PDI )
● Personal Disposable Income (PDI ) = PI – Personal tax payments –
Non-tax payments.

● Personal Disposable Income is the part of the aggregate income which

belongs to the households. They may decide to consume a part of it, and
save the rest.
Problems
● From the following data, calculate Personal Income and Personal
Disposable Income.
● Rs (crore)
● (a) Net Domestic Product at factor cost 8,000
● (b) Net Factor Income from abroad(NFIA) 200
● (c) Undisbursed Profit 1,000
● (d) Corporate Tax 500
● (e) Interest Received by Households 1,500
● (f) Interest Paid by Households 1,200
● (g) Transfer Income 300
● (h) Personal Tax 500
Approaches to compute GDP
1. Income Approach
2. Expenditure Approach
3. Production Approach
Product method
● In product method we calculate the aggregate annual value of goods and
services produced

● The term that is used to denote the net contribution made by a firm is
called its value added.
Product method
● the raw materials that a firm buys from another firm which are
completely used up in the process of production are called ‘intermediate
goods’.
● Therefore the value added of a firm is, value of production of the firm –
value of intermediate goods used by the firm.
● The value added of a firm is distributed among its four factors of
production, namely, labour, capital, entrepreneurship and land. Therefore
wages, interest, profits and rents paid out by the firm must add up to the
value added of the firm.
● GVA=GDP
Value added
Producer Farmer Baker

Value of output Rs. 50000 Rs. 100000

Value of intermediate Rs.10000 Rs.50000

goods

Value added
Expenditure method
● An alternative way to calculate the GDP is by looking at the demand side
of the products.
● This method is referred to as the expenditure method
● Total expenditure or Y= C + I + G + (X-M)

● C=Private consumption expenditure

● I= Investment expenditure
● G=Government expenditure
● X-M= Net exports( exports-imports)
● Consumption

● consisting of private expenditures (household final consumption

expenditure) in the economy. Personal expenditures fall under one of the
following categories: durable goods, non-durable goods, and services.
● Investment
● investment includes, for instance, business investment in equipment, but
does not include exchanges of existing assets. Spending by households
(not government) on new houses is also included in Investment.

● “Investment” in GDP does not mean purchases of financial products. It is

important to note that buying financial products is classed as ‘ saving,’ as
opposed to investment.
● Government Expenditure

● “G” ( government spending ) is the sum of government expenditures on

final goods and services. It includes salaries of public servants, purchase
of weapons for the military, and any investment expenditure by a
government. However, since GDP is a measure of productivity, transfer
payments made by the government are not counted because these
payment do not reflect a purchase by the government, rather a
movement of income.
● Net exports

● “X” (exports) represents gross exports. GDP captures the amount a

country produces, including goods and services produced for other
nations’ consumption, therefore exports are added.
● “M” (imports) represents gross imports. Imports are subtracted since
imported goods will be included in the terms “G”, “I”, or “C”, and must be
deducted to avoid counting foreign supply as domestic.
Income Method
● the sum of final expenditures in the economy must be equal to the
incomes received by all the factors of production taken together
● revenues earned by all the firms put together must be distributed among
the factors of production as salaries, wages, profits, interest earnings and
rents.
● The sum of such factor payments equals Net value Added at Factor Cost
(NVAfc) by that sector. Then we take sum total of NVAfc by all the sectors to
arrive at NDPfc. The components of NDPfc are:

● 1.Compensation of employees
● 2. Rent and royalty
● 3. Interest
● 4. Profits
● NDP fc= Compensation of employees +Rent and royalty +Interest+ profit
Problems with National Income estimation
1. Double counting problem
2. Definition of goods and services to be included
3. Calculation of depreciation
4. Excluded Market Transactions( self consumed items)
Problems
● Calculate NNPfc

GDPmp= Rs.5000
Depreciation= 720
NFIA=400
Indirect tax=300
Subsidies=120
NDP=5000-720=4280