UNIT -5

National Income
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.

According to Marshall: “The labour 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.

Concepts of National Income:

There are various concepts of national income which we study one by one.

1. GDP and GNP:

GDP measures the aggregate money value of output produced by the economy over a year. In
other words, GDP is obtained by valuing all final goods and services produced domestically in a
year at market prices. GDP is also calculated by adding all the incomes generated by the act of
production.

Since only domestically produced goods and services is estimated, we use the
word ‘domestic’ to distinguish it from the gross national product. The word ‘gross’ means that
no deduction for depreciation is allowed.
GNP includes GDP plus net property income from abroad. Thus, GNP includes income that
nationals earn abroad, but it does not include the income earned by foreign nationals. On the
other hand, GDP is concerned with incomes generated domestically even by the foreigners.
GDP ignores incomes received from abroad.

It is a measure of the goods and services produced within the country, regardless of who owns
the assets. And, GNP is the total of incomes earned by the residents of a country, regardless of
where the assets are located. India’s GNP includes profits from Indian- owned businesses
located in other countries.

In other words,

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GNP = market value of domestically produced goods and services + incomes earned by the
nationals in foreign countries — incomes earned in the country by the foreigners

GDP = market value of goods and services produced in the country + incomes earned in the
country by the foreigners — incomes received by resident nationals from abroad.

An example will help our understanding. Suppose, an Indian doctor goes to the USA temporarily
to work there. The income he earns by rendering his service in the USA is included in the US
GNP and not India’s GDP because it is earned in the USA.

But this income is not part of the US GDP because the Indian doctor is a foreign national there.
Similarly, the income of a US ambassador in New Delhi is included in the US GNP, but it is a part
of India’s GDP. Thus,

GNP = GDP + net property income from abroad

Thus GDP measures the aggregate money value of all goods and services produced by factors of
production located and paid for in the domestic economy, even if these factors are owned
abroad.

2. GDP at Market Price and GDP at Factor Cost:

When national product is measured, it is measured at current market prices. Market prices
always reflect taxes and subsidies on the commodities produced. If indirect taxes are imposed
on commodities, market prices of the commodities go up. A 10 p.c. tax on a book on economics
will raise its price.

Tax is included in the price of a commodity and tax is not a production. Similarly, subsidies are
provided to some commodities, as a result of which prices decline. If we do not make any
adjustment for such taxes and subsidies, we obtain GDP at market price.

GDP at market prices does not reflect true incomes of factors of production. It includes taxes
and subsidies but such are not production and, hence, they cannot be treated as incomes of
productive inputs.

So, taxes and subsidies are to be excluded and included to obtain the true figure of production.
Value of output can never be equal to the value of incomes paid to all productive inputs. By
adjusting taxes and subsidies, we obtain GDP at factor cost, i.e.,

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GDP at factor cost = GDP at market price – indirect taxes (T) + subsidies (SU)
An example may be given here. Suppose,an excise duty on Nano car has been imposed.

As a result of this, price of the car goes up to Rs. 1.75 lakh (Rs. 5 thousand being the excise
duty). Value of the car output is, in fact, Rs. 1.70 lakh. This means different factor inputs have
earned incomes in the form of rent, wages, etc., to the extent of Rs. 1.70 lakh. Value of output
must equal the value of incomes generated. Thus, indirect taxes are to be excluded.

Subsidies have the opposite effect of taxes. A subsidy per unit of coarse cotton cloth has the
effect of reducing its market price. As a result of, say, one rupee subsidy per meter, consumers
get the cotton cloth at Rs. 20 per meter.

But incomes received by the input owners in this cloth mill are Rs. 21 per meter. Value of
output must equal the value of all incomes. So, subsidies are to be added. Thus, by subtracting
taxes and adding subsidies from GDP at market price, one obtains GDP at factor cost.

GNP at market prices and GNP at factor cost are calculated in the same way as described
above:
NI = NNP – T + SU
Or, NI = (GNP – D) – T + SU
3. NNP:
If we deduct depreciation from gross product we obtain net product. GDP minus depreciation is
called NNP. NNP is sometimes called national income.

Anyway, to measure NNP, we must make a distinction between gross investment (I G) and net
investment (IN). Gross investment refers to total expenditure for new plant, equipment, etc.,
plus the change in inventories. Net investment is equal to gross investment less depreciation.
That is,

IN = IG – depreciation
Since, GNP = C + IG + G + (X – M),
NNP = C + IN + G + (X – M)
Or, NNP = GNP – depreciation

Although NNP gives us the better measure of an economy’s performance, we pay more
attention to GNP. This is because estimation of NNP is difficult in practice, as one has to

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measure depreciation to obtain the net investment figure. In practice, GNP is the more
commonly used indicator than NNP.

4. Personal Income:
Although national income is the sum total of all individuals’ personal income, it is observed that
received income is smaller than the earned income. This is because first a company has to pay
corporate income tax (TC) to the government out of its earned income. Secondly, firms keep a
portion of their profits for internal expansion.
This is called undistributed corporate profit (PC) or retained earnings. Thirdly, individuals pay
social security taxes (TS), like provident fund, life insurance premium, etc. Finally, since
government transfer payments (TR) do not reflect current earnings and, hence, are not included
in national income, it increases received income.
To measure personal income (PI), we subtract TC, PC, and TS (i.e., all the components of income
that is earned but not received) from NI and add T R (i.e., income received but not earned) from
national income. Symbolically,
PI = NI – (TC + PC + TS) + TR
We can summarize this discussion in the following form:

Here, TD refers to direct tax, DI to disposable income, S to saving, and C to consumption.

Personal Income =National Income —Social Security Contributions —Corporate Income

Taxes—Undistributed Corporate Profits + Transfer Payments.
Disposable Income = Personal Income—Personal Taxes.

Disposable Income can either be consumed or saved. Therefore, Disposable Income =

Consumption + Saving.

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Methods of Measuring National Income:

1. Value-added Method:
Value added method, also called net output method, is used to measure the contribution of an
economy’s production units to the GDPmp. In other words, value-added method measures
value added by each industry in an economy. For calculating national income through value-
added method, it is necessary to first calculate gross value added at market price (GVAmp), net
value added at market price (NVAmp), and net value added at factor cost (NVAfc).

These can be calculated as follows:

(i) GVAmp:
Refers to the value of output at market prices minus intermediate consumption. The value of
output can be calculated by multiplying quantity of output produced by a production unit
during a given time period with price per unit. For instance, if output produced by a production
unit in a year is 10000 units at price Rs. 10 per unit, then the total value of output would be
100000.

The value of output is also calculated as:

Value of output = Total Sales + Closing Stock – Opening Stock

Where

Net change in stock = Closing Stock – Opening Stock

Glossing stock includes the value of unsold output in the previous year and forms the opening
stock of the current year. Thus, by deducting the opening stock from the closing stock, unsold
output of the current year can be calculated.

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On the other hand, intermediate consumption refers to the value of non-durable goods and
services purchased by a production unit from another production unit in particular period of
time. These goods and services used up or resold during that particular period of time.

So, GVAmp can be calculated using the following formula:

GVAmp = Value of Output Intermediate Consumption

The word gross in GVAmp indicates the inclusion of depreciation.

(ii) NVAmp:
Excludes depreciation from GVAmp. In other words, NVAmp is GVAmp minus depreciation.

(iii) NVAfc:
Refers to another measure of value added.

It is calculated as:
NVAfc = NVAmp Indirect Taxes + Subsidies

Or

NVAfc = GVAmp Depreciation Indirect Taxes + Subsidies

Now, using the value-added method, we aim to calculate national income (NNPfc).

The following are the steps to calculate national income using the value-added method:
1. Classifying the production units into primary, secondary, and tertiary sectors.

2. Estimating Net Value Added (NVAfc) of each sector.

3. Taking the sum of NVAfc of all the industrial sectors of the economy. This will give NDPfc.

ΣNVAfc = NDPfc

4. Estimating NFIA and adding it to NDPfc, which gives NNPfc (national income).

NDPfc + NFIA = National Income (NNPfc)

2. Income Method:

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Income method, also known as factor income method, is used to calculate all income accrued
to the basic factors of production used in producing national product. Traditionally, there are
four factors of production, namely land, labor, capital, and organization. Accordingly there are
four factor payments, namely rent, compensation of employees, interest, and profit. There is
another category of factor payment called mixed income.

These factor payments are explained as follows:

(a) Rent:
Refers to the amount payable in cash or in kind by a tenant to the landlord for using land. In
national income accounting, the term rent is restricted to land and not to other goods, such as
machinery.

In addition to rent, royalty is also included in national income which is defined as the amount
payable to landlord for granting the leasing rights of assets that can be extracted from land, for
example, coal and natural gas.

(b) Compensation of Employees:

Refer to the remuneration paid to employees in exchange of services rendered by them for
producing goods and services.

Compensation of employees is divided into two parts, which are as follows:

(i) Wages and salaries:

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Include remuneration given in the form of cash to employees on a daily, weekly, or monthly
basis. It includes allowances, such as conveyance allowance, bonuses, commissions, rent-free
accommodation, loans on low interest rates, and medical and educational expenses.

(ii) Social security contribution:

Includes remuneration provided to employers in the form of social security schemes such as
insurance, pensions, and provident fund.

(c) Interest:
Refers to the amount payable by the production unit for using the borrowed money

(d) Profits:
Refers to the amount of money earned by the owner of a production unit for his/her
entrepreneurial abilities. Thus, profit Is the sum total of corporate profit tax, dividend, and
retained earnings.

(e) Mixed Income:

Refers to earnings from farming enterprises, sole proprietorships, and other professions, such
as medical and legal practices.

National Income Rent + Wages + Interest + Profit + Mixed Income

Now, let us discuss steps involved in estimating national income using the income method.

These steps are as follows:

1. Classifying the production units into primary, secondary, and tertiary sectors.

2. Estimating Net Value Added (NVAfc) of each sector. The sum total of the factor payments
equals NVAfc.

3. Taking the sum of NVAfc of all the industrial sectors of the economy. This will give NDPfc.

ΣNVAfc = NDPfc

4. Estimating NFIA and adding it to NDPfc, which gives NNPfc (national income).

NDPfc + NFIA = National Income (NNPfc)

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3. Final Expenditure Method:
Final expenditure method, also known as final product method, is used to measure final
expenditures incurred by production units for producing final goods and services within an
economic territory during a given time period.

These expenditures are incurred on consumption and investment. This method is the opposite
of the value-added method. This is because value-added method estimates national income
from the sales side, whereas the expenditure method calculates national income from the
purchase side.

Final expenditure of an economy is divided into consumption expenditure and investment

expenditure, which are explained as follows:
(a) Consumption Expenditure:
Includes the following:
(i) Private Final Consumption Expenditure (PFCE):
Includes expenditure incurred by households and expenditure incurred by private non-profit
institutions serving households (PNPISH). Thus, PFCE is divided into two parts, namely
Household’s Final Consumption Expenditure (HFCE) and PNPISH Final Consumption Expenditure
(PNPISH-FCE).

HFCE can be calculated with the help of the following formula:

HFCE = Money expenditure on consumption by residents + Imputed value of consumer goods
and services received in kind by residents – Sale of pre-owned goods, wastes, and scraps

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On the other hand, PNPISH includes expenditure incurred by private charitable institutions,
trade unions, and religious societies, which produce goods and services to be supplied to
consumers either free or at token prices.

PNPISH-FCE = Imputed value of goods and services produced Commodity and non-commodity
sales

Commodity sales imply the sale at a price that covers cost, while non-commodity sales imply
the sale at a price that does not cover cost.

(ii) Government Final Consumption Expenditure (GFCE):

Includes expenditure that is incurred by government for providing free goods and services to
citizens. GFCE is equal to value of output minus sales (GFCE = Value of Output – Sales).

The value of output is calculated as:

Value of output generated by government = Compensation of government employees +
purchases of commodities and services + consumption of fixed capital

Sales by government = Commodity Sales + Non- Commodity Sales

(b) Investment Expenditure:

Involves expenditure incurred on capital formation. This expenditure is known as Gross
Domestic Capital Formation (GDCF).

There are three components of GDCF, which are as follows:

(i) Acquisition of fixed capital assets:
Implies purchasing assets, such as building and machinery.

(ii) Change in stocks:

Involves making addition to the stock of raw materials, semi-finished goods, and finished goods.

(iii) Net acquisition of valuables:

Involves acquisition of valuables minus disposal of valuables. These valuables include precious
stones, metals, and jewellery.

GDCF becomes net when it is diminished by depreciation.

Net GDCF = GDCF – depreciation

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GDCF is subdivided into Gross Domestic Fixed Capital Formation (GDFCF) and change in stocks.

Now, let us discuss steps involved in estimating national income using final expenditure
method.

These steps are as follows:

1. Classifying the production units into primary, secondary, and tertiary sectors.

2. Estimating the final expenditures on goods and services by industrial sectors. These
expenditures are PFCE, GFCE, and GDCF. The expenditure also includes net exports, which are
equal to exports minus imports.

3. Taking the sum of the final expenditures which gives GDPmp.

GDPmp = PFCE + GFCE + GDCF + Net Exports

4. Estimating the consumption of fixed capital and net indirect taxes to calculate NDPfc.

NDPfc = GDPmp – Consumption of Fixed Capital- Net Indirect Taxes

5. Adding NFIA to get national income (NNPfc)

NDPfc +NFIA = NNPfc

Circular Flow in 2, 3, 4 sector

Circular Income Flow in a Two Sector Economy

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.

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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 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.

Circular Income Flow in a Three Sector Economy with Government

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.

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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.

Money Income Flows in the Four Sector Open Economy

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.

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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 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.

Inflation
Inflation is a situation in which the general price level rises or it is the same thing as saying that

the value of money falls.

According to Coulbrun, “too much money chasing to few goods”. Crowther defines, “inflation is

a state in which the value of money is falling”.

Types of Inflation:
On the basis of the rate of increase in price level we have three types of inflation,

(i) Creeping Inflation:

It is also known as mild-inflation. It is not dangerous especially in an economy where national

income is also rising. There are some economists who regard a mild increase in the price level

as a necessary condition for economic growth.

(ii) Galloping Inflation:

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If mild inflation is not checked and if it is allowed to go uncontrolled, it may assume the

character of the galloping inflation. It may have adverse effect on saving and investment in the

economy.

(iii) Hyper-Inflation:

A final stage of inflation is hyper-inflation. It occurs when the Priceline goes out of control and

the monetary authorities find it beyond their resources to impose any checks on it. At this

stage, there is no limit to which the price level may rise.

Causes of Inflation:
The causes of inflation may be grouped under two headings:

(1) Demand-pull Inflation:

The inflation represents a situation whereby “The pressure of aggregate demand for goods and

services exceeds the available supply of output.” In such situation, the rise in price level is the

natural consequence.

Now this excess of aggregate demand over supply may be the result of more than one force at

work. As we know, aggregate demand is the sum of consumer’s spending on current goods and

services and net investment being contemplated by the entrepreneurs.

At times, however, the government, the entrepreneurs or the households may attempt to

secure a larger part of output than would thus accrue to them. Inflation is thus caused when

aggregate demand for all purposes-consumption, investment and government expenditure

exceeds the supply of goods at current prices. This is called demand-pull inflation.

(2) Cost-Push Inflation:

Even though there is no increase in aggregate demand, prices may still rise. This may happen if

costs, particularly the wage costs, go on rising. Now as the level of employment rises, the

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demand for workers also rises, so that the bargaining position of the workers becomes

stronger.

To exploit this situation, they may ask for an increase in wage rates which are not justifiable on

grounds either of a prior rise of productivity or of cost of living. The employers in a situation of

high demand and employment are more agreeable to concede these wage claims, because they

hope to pass on this rise in cost to the consumers in the shape of rise in prices. If this happens,

we have another inflationary factor at work and the inflation thus caused is called the wage-

induced or cost-push inflation.

Business Cycle

The term “business cycle” (or economic cycle or boom-bust cycle) refers to economy-wide

fluctuations in production, trade, and general economic activity. From a conceptual

perspective, the business cycle is the upward and downward movements of levels of GDP (gross

domestic product) and refers to the period of expansions and contractions in the level of

economic activities (business fluctuations) around a long-term growth trend

Phases of a Business Cycle

Business cycles are characterized by boom in one period and collapse in the subsequent period
in the economic activities of a country.

These fluctuations in the economic activities are termed as phases of business cycles.

The different phases of business cycles are shown in Figure-1:

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There are basically two important phases in a business cycle that are prosperity and depression.
The other phases that are expansion, peak, trough and recovery are intermediary phases.

Figure-2 shows the graphical representation of different phases of a business cycle:

As shown in Figure-2, the steady growth line represents the growth of economy when there are
no business cycles. On the other hand, the line of cycle shows the business cycles that move up
and down the steady growth line. The different phases of a business cycle (as shown in Figure-
2) are explained below.
1. Expansion:
The line of cycle that moves above the steady growth line represents the expansion phase of a
business cycle. In the expansion phase, there is an increase in various economic factors, such as
production, employment, output, wages, profits, demand and supply of products, and sales.

In addition, in the expansion phase, the prices of factor of production and output increases
simultaneously. In this phase, debtors are generally in good financial condition to repay their
debts; therefore, creditors lend money at higher interest rates. This leads to an increase in the
flow of money.

In expansion phase, due to increase in investment opportunities, idle funds of organizations or

individuals are utilized for various investment purposes. Therefore, in such a case, the cash
inflow and outflow of businesses are equal. This expansion continues till the economic
conditions are favorable.

2. Peak (Boom):

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The growth in the expansion phase eventually slows down and reaches to its peak. This phase is
known as peak phase. In other words, peak phase refers to the phase in which the increase in
growth rate of business cycle achieves its maximum limit. In peak phase, the economic factors,
such as production, profit, sales, and employment, are higher, but do not increase further. In
peak phase, there is a gradual decrease in the demand of various products due to increase in
the prices of input.

The increase in the prices of input leads to an increase in the prices of final products, while the
income of individuals remains constant. This also leads consumers to restructure their monthly
budget. As a result, the demand for products, such as jewellery, homes, automobiles,
refrigerators and other durables, starts falling.

3. Recession:
In peak phase, there is a gradual decrease in the demand of various products due to increase in
the prices of input. When the decline in the demand of products becomes rapid and steady, the
recession phase takes place.

In recession phase, all the economic factors, such as production, prices, saving and investment,
starts decreasing. Generally, producers are unaware of decrease in the demand of products and
they continue to produce goods and services. In such a case, the supply of products exceeds the
demand.

This situation is firstly considered as a small fluctuation in the market, but as the problem exists
for a longer duration, producers start noticing it. Consequently, producers avoid any type of
further investment in factor of production, such as labor, machinery, and furniture. This leads
to the reduction in the prices of factor, which results in the decline of demand of inputs as well
as output.

4. Trough:
During the trough phase, the economic activities of a country decline below the normal level. In
this phase, the growth rate of an economy becomes negative. In addition, in trough phase,
there is a rapid decline in national income and expenditure.

In this phase, it becomes difficult for debtors to pay off their debts. As a result, the rate of
interest decreases; therefore, banks do not prefer to lend money. Consequently, banks face the
situation of increase in their cash balances.

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Apart from this, the level of economic output of a country becomes low and unemployment
becomes high. In addition, in trough phase, investors do not invest in stock markets. In trough
phase, many weak organizations leave industries or rather dissolve. At this point, an economy
reaches to the lowest level of shrinking.

5. Recovery:
As discussed above, in trough phase, an economy reaches to the lowest level of shrinking. This
lowest level is the limit to which an economy shrinks. Once the economy touches the lowest
level, it happens to be the end of negativism and beginning of positivism.

This leads to reversal of the process of business cycle. As a result, individuals and organizations
start developing a positive attitude toward the various economic factors, such as investment,
employment, and production. This process of reversal starts from the labor market.

In recovery phase, consumers increase their rate of consumption, as they assume that there
would be no further reduction in the prices of products. As a result, the demand for consumer
products increases.

In addition in recovery phase, bankers start utilizing their accumulated cash balances by
declining the lending rate and increasing investment in various securities and bonds. Similarly,
adopting a positive approach other private investors also start investing in the stock market As
a result, security prices increase and rate of interest decreases.

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