Module IV Concepts of National Income

• Concepts of GDP, GNP, NI and Disposable income.

• Aggregate demand and supply (Both open and closed economies)
• Basic concepts of inflation, deflation, stagflation, business cycles and BOP

Circular flow of income in two, three, four sector economy;

Circular Flow of Income in a Four-Sector Economy! Circular flow of income in a four-sector

economy consists of households, firms, government and foreign sector.

Circular flow of income

The circular flow of income or circular flow is a model of the economy in which the major exchanges are
represented as flows of money, goods and services, etc. between economic agents. The flows of money and
goods exchanged in a closed circuit correspond in value, but run in the opposite direction
The term investment multiplier refers to the concept that any increase in public or private investment spending
has a more than proportionate positive impact on aggregate income and the general economy.

What is a 2-sector economy?

a) Household sector: It includes consumers of goods and services. Households are also the owners of the
factors of production.
b) Producer sector: It includes all producing units in the economy. For the production of goods and services,
the firms purchase factors of production.
National income
National income means the value of goods and services produced by a country during a financial year. Thus,
it is the net result of all economic activities of any country during a period of one year and is valued in terms
of money.

The broadest and most widely used measure of national income is gross domestic product (GDP), the value
of expenditures on final goods and services at market prices produced by domestic factors of production
(labor, capital, materials) during the year.

Now, there are several methods of calculating national income. The three most common methods are the
value-added method, the income method, and the expenditure method.
Income Method

Income method National income is calculated using this method as a flow of factor incomes. Labor, capital,
land, and entrepreneurship are the four main components of production. Labour is compensated with wages
and salaries, money is compensated with interest, the land is compensated with rent, and entrepreneurship is
compensated with profit.

Expenditure Method

Expenditure Method The gross domestic product (GDP) is the total of all private consumption expenditures.
Government consumption expenditure, gross capital formation (public and private), and net exports are all
factors to consider (Export-Import). As said above, the flow of expenditure is used to calculate national
income. The Expenditure technique can be used to calculate NI as follows: National
Income+NationalProduct+NationalExpenditure=National Income +National Product + National
Expenditure=National Expenditure.

Value added method

The sum total of products produced in all sectors is the total output of the nation. The next step is to find out
the value of these products in terms of money. The money sent by Indian citizens working abroad is also
added to this. Now we get the gross national income. G.N.P. - COST OF CAPITAL – DEPRECIATION –
INDIRECT TAXES = NATIONAL INCOME

Injection in the Economy

Injections are the addition of money to the circular flow of income. Examples are investments, government
expenditure, and export payments. It includes:

1. Exports: Goods sold to foreign countries by the firms, tends to increase the income flow as payment is
received from the foreign countries for the purchase of domestic goods. Hence, it injects income from the
foreign market into the domestic financial market.

2. Investments: That portion of income that is put to purchase the capital asset, which generates a return in
the future. It is the total expense made by the firm on capital expansion, which infuses money into the goods
market.

3. Government Expenditure: Total consumption expenditure made by the government, be it central, state, or
local self-government, on the purchase of goods and services, providing subsidies to the firms, and transfer
payments (social security schemes, pensions, retirement benefits, etc.) to the households. So, Injections =
Investments + Government Expenditure + Exports

Leakage in the economy

A leakage means the withdrawal of a part of the income from the circular flow of income. For instance,
savings and taxes by households and firms as well as import payments are forms of leakage. It includes:

1. Savings: That portion of the income of a household or firm which is not spent on purchasing goods and
services, or distributed as profit, but retained for the future.

2. Imports: Goods bought from foreign countries and so the payment is made to foreign countries, which is
an outflow of income from the economy.
3. Taxes: Taxes is the amount paid by individuals and firms to the government. It flows to the government
and not to the goods market. Hence, Leakages = Savings + Taxes + Imports. They reduce the overall
magnitude of income from the circular flow.

Real versus nominal GDP

GDP
It is the market value of all the goods and services produced by an economy in a given Financial Year The
GDP helps in determining the economic growth purchasing power and overall economic health of a country

Real GDP tracks the total value of goods and services calculating the quantities but using constant prices that
are adjusted for inflation. This is opposed to nominal GDP that does not account for inflation.

Real Gross Domestic Product is a way of measuring a nation’s output in terms of the value of its good and
services its investments government spendings and exports with the prices of the base year

Real GDP is a macroeconomic statistic that measures the value of the goods and services produced by an
economy in a specific period, adjusted for inflation.
Nominal GDP
Nominal GDP measures output using current prices, but real GDP measures output using constant prices.

A real interest rate is adjusted to remove the effects of inflation and gives the real rate of a bond or loan. A
nominal interest rate refers to the interest rate before taking inflation into account

Real GDP tracks the total value of goods and services calculating the quantities but using constant prices that
are adjusted for inflation. This is opposed to nominal GDP that does not account for inflation.

Nominal GDP

Nominal gross domestic product is GDP that is evaluated at the present market prices. GDP is the financial
equivalent of all the complete products and services generated within a nation in a definite time. The nominal
varies from the real and incorporates changes in cost prices due to an increase in the complete cost price.
Generally, economists utilise a gross domestic factor to change the nominal GDP to the real GDP, which is
also known as current dollar GDP or chained dollar GDP.

Real GDP

Real GDP is an inflation-adjusted calculation that analyses the rate of all commodities and services
manufactured in a country for a fixed year. It is expressed in foundation year prices and referred to as a fixed
cost price. It is also known as inflation-corrected GDP or constant price GDP. The real GDP is regarded as a
reliable indicator of a nation’s economic growth as it solely considers production and is free from currency
fluctuations
Business Cycle
A business cycle is the periodic growth and decline of a nation's economy, measured mainly by its GDP.
Governments try to manage business cycles by spending, raising or lowering taxes, and adjusting interest
rates. Business cycles can affect individuals in a number of ways, from job-hunting to investing.
What are the 4 stages of the business cycle?
The four stages of the cycle are expansion, peak, contraction, and trough. Factors such as GDP, interest rates,
total employment, and consumer spending, can help determine the current stage of the economic cycle.

PHASES OF BUSINESS CYCLE

EXPANSION
• Wages increase
• Low unemployment
• People are optimistic
• There is high demand for goods and services
• Businesses starts
• Easy to get a bank loan
• Business makes profits and stock prices increase

PEAK
• The economy stops growing
• GDP reaches maximum
• Business firms can't produce any more or hire more labor
• Thus cycles begins to contract

CONTRACTION
• Businesses cut back production and layoff people.
• Unemployment increases.
• Numbers of jobs decline
• People are negative and stop their spending
• Banks stops lending money.
TROUGH
• Economy "bottoms-out"(reaches lowest points)
• High unemployment and low spending
• Stock prices decrease

NOW WHAT KEEPS THE BUSINESS CYCLES GOING?

• BUSINESS INVESTMENTS
• INTEREST RATES AND CREDIT
• CONSUMER EXPECTATIONS
• EXTERNAL SHOCKS
Inflation
Inflation is the rate of increase in prices over a given period of time. Inflation is typically a broad measure,
such as the overall increase in prices or the increase in the cost of living in a country.
In economics, inflation refers to a general increase in prices of goods and services in an economy. When the
general price level rises, each unit of currency buys fewer goods and services; consequently, inflation
corresponds to a reduction in the purchasing power of money.

There are three main causes of inflation: demand-pull inflation, cost-push inflation, and built-in inflation.
The three types of Inflation are Demand-Pull, Cost-Push and Built-in inflation.
• Demand-pull Inflation: It occurs when the demand for goods or services is higher when compared to
the production capacity. ...
• Cost-push Inflation: It occurs when the cost of production increases.

Key Takeaways. Governments can use wage and price controls to fight inflation, but that can cause recession
and job losses. Governments can also employ a contractionary monetary policy to fight inflation by reducing
the money supply within an economy via decreased bond prices and increased interest rates.

Inflation can be controlled by a contractionary monetary policy is one common method of managing
inflation. A contractionary policy aims to reduce the supply of money within an economy by lowering the
prices of bonds and rising interest rates. Thus, consumption falls, prices fall and inflation slows down.

India uses whole sale price index (WPI) to calculate and decide the inflation rate in economy.
WPI- WPI is the index that is used to measure the change in average price level of goods traded in whole sale
market. In India total of 435 commodities data on price level tracked through WPI is an indicator of movement
prices in trade and transactions
Balance of payment
In international economics, the balance of payments of a country is the difference between all money flowing
into the country in a particular period of time and the outflow of money to the rest of the world.

Balance of payments
The balance of payments (BOP), also known as the balance of international payments, is a statement of all
transactions made between entities in one country and the rest of the world over a defined period, such as a
quarter or a year.

The BoP consists of three main components—current account, capital account, and financial account. As
mentioned earlier, the BoP should be zero.

Difference between BoT and BOP

Balance of trade (BoT) is the difference that is obtained from the export and import of goods. Balance of
payments (BoP) is the difference between the inflow and outflow of foreign exchange. Transactions related
to goods are included in BoT. Transactions related to transfers, goods, and services are included in BoP.

Current account
The current account represents a country's imports and exports of goods and services, payments made to
foreign investors, and transfers such as foreign aid.

(1) Current Account:

Current account refers to an account which records all the transactions relating to export and import of goods
and services and unilateral transfers during a given period of time.

ADVERTISEMENTS:

Current account contains the receipts and payments relating to all the transactions of visible items, invisible
items and unilateral transfers.

The main components of Current Account are:

• Export and Import of Goods (Merchandise Transactions or Visible Trade):

• Export and Import of Services (Invisible Trade):

 • Unilateral or Unrequited Transfers to and from abroad (One sided Transactions):

• Income receipts and payments to and from abroad:

(2) Capital Account:

Capital account of BOP records all those transactions, between the residents of a country and the rest of the
world, which cause a change in the assets or liabilities of the residents of the country or its government. It is
related to claims and liabilities of financial nature.

The main components of capital account are:

• Borrowings and landings to and from abroad: It includes:
• Investments to and from abroad: It include the four main components of production. Labour is
compensated with wages and salaries, money is compensated with interest, the land is compensated
with rent, and entrepreneurship is compensated with profit.