Circular Flow of Income

F.Y.B.L.S – Economics
Sem I
Module 1
 Meaning of Income?

 Wages, Profit, Interest, Rent, Gift, Donation etc

 Give and Take – Labour receives wages for his services – Factor Income – Significant in
National Income

 Only ‘Transfer of Money’ without any exchange of services – Non-Factor Income

 Meaning of Income?
 Factors of Production
 Factor Income - types – Wage, Rent, Income and Profit
 Labour includes all physical and mental efforts of the human
beings involved in production, Its remuneration is termed as
compensation of employees.
 Land includes all free gifts of nature and its remuneration is
termed as rent.
 Capital includes all man-made capital goods and its remuneration
is termed as interest
 The entrepreneurthe owner of the business who earns profit.
 The joint effort of the land, labour, capital, and
entrepreneur generates income
 Circular Flow of Income
 The circular flow of money refers to the process whereby money payments and receipts of an
economy flow in a circular manner continuously over a period of time.

 An economy performs certain economic activities which enables it to function smoothly. The
important activities are (i) production (ii) exchange (ii) consumption and (iv) distribution.

 Money has become an essential element of economic transaction or exchange in the modern
economic structure

 Flows of Goods and Services are ‘Real Flow’ - Difficult to measure

 Flows of Money are ‘Money Flow’

 The economic agent involved are mainly Household and Firms – (other agents are Government, Foreign
sector)
Two Sector Economy
 Two Sector Economy
1. The economy consist of two sectors namely household and business or firms
2. Household sector spends their entire income received in the form of rent, wages,
interest and profits from the business sector on buying of goods and services
produced by the firms. They do not hold or save any part of their income.
3. The business firms keep their production exactly equally to their sales or as much as
demanded by the households. There are no changes in their inventories.
4. The business sector does not keep any undistributed money as reserve. The money
it receives by selling goods and services to the household sector is fully spent in
making payments as rent, wages, interest and profits to the household sector.
5. There are no government operations.
6. There is no inflow or outflow of income or no foreign trade.
Two Sector Economy – Saving and Investment
 Three Sector Economy
1. Household
2. Firm
3. Government

 Government Taxes
 Government
spends on goods
and services,
pension payments,
unemployment
allowance etc.
 Four Sector Economy
1. Household
2. Firm
3. Government
4. Foreign Sector

 Export and Import

 Significance of Circular Flow of Income

1. To understand the functioning of the economy (good or bad) and for helping the government in
formulating polity measures.

2. To understand the link between producers and consumers

3. To find out the leakages in circular flow of income

4. Highlights the importance of monetary and fiscal policies

 National Income
 National Income is defined as the sum total of all the goods and services produced in a country,
in a particular period of time.
 Usually One year time frame is considered for calculating
 Any Goods and Services produced in any given year must be counted only once (final goods
and services)
 Central Statistical Organization defines National income as “National Income is the sum of
factor income earned by the normal residents of a country in the form of wages, rent, interest
and profit in an accounting year.”
 It represents –
1. National Income
2. National Product
3. National Expenditure
 Features of National Income
1. Flow Concept (not the Stock)

2. Value of Final Goods

3. Macro-economic Concept

4. Monetary Measures (Value of Goods and services are estimated with

the help of Money)

5. Adds Net export (export minus import)

6. Measure of economic progress

 Difficulties in Calculating National Income
1. Treatment of Non-Monetary Transaction (Goods and Services
transacted without money – Barter system, Housewives service)

2. Double Counting

3. Transfer Incomes (transfer payment received without any contribution

to output - Pension, scholarship, unemployment benefit etc)

4. Government Incomes (Government may receive profit its not only

expenditure)

5. Income from Illegal activities.

 Difficulties in Calculating National Income
6. Imputed values (goods and services that did not enter the market
for transaction – goods produced and consumed by farmers,
fringe benefits enjoyed by owners/top executive of the firm)

7. Difficulty in depreciation analyses

8. Lack of expense accounting unorganised sector and remote areas

9. Non-availability of data/ error in data

10. Secrecy of Income.

 Gross Domestic Product (GDP)
 Gross Domestic Product is the market value of the final goods and services produced within
the domestic territory of a country during one year.

 The domestic territory is much bigger than the political frontiers of a country.

 Thus, definition includes –

 Territory lying within the political frontiers including territorial waters of the country.
 Ships and Aircrafts operated by the residents of the country between two or more countries.
 Fishing vessels, oil and natural gas rigs and floating platforms operated by the residents of the
country.
 Embassies, Consulates and Military establishments of the country located abroad.
 GDP calculation includes income of foreigners in a Country but excludes income of those
people who are living outside of that country.
 Gross Domestic Product (GDP)
 GDP includes –
1. Wages and salaries
2. Rent
3. Interest
4. Dividends
5. Undistributed Profit
6. Mixed income
7. Direct taxes.

 GDP = C+I+G + (X-M)

 Where, C = Consumption
 I = Investment
 G = Govermment's expenditure on goods and services
 X-M = Export – Import
 Here, (X – M) refers to net exports which can be positive or negative. If exports are greater than imports, net
exports will be positive and vice versa. Net positive exports will lead to rise in GDP and net negative exports will
lead to fall in GDP.
 Gross National Product (GNP)
 GNP at market price is sum total of all the goods and services produced in a country during a
year and net income from abroad.
 GNP is defined as the total market value of all final goods and services produced in a year.
 It measures the market value of a yearly output and therefore it is a monetary measure of
national income.
 GNP can be determined as a flow of products produced or as a sum of eamings of factors of
production.
 The former method treats GNP as the total money value of the flow of final products produced
by the nation.
 The later method treats it as the total of factor earnings (wages, interest, rents later and profits).
 In a closed economy there is no difference between Gross Domestic Product (GDP) and Gross
National Product (GNP).
 Difference between GDP and GNP
1. It is the total money value of goods and
services produced in the nation during a
given year.
2. The income earned by nationals whether
inside or outside the country is included in
GNP
3. The part of income produced in the
country but earned by foreigners is
excluded from GNP.
4. GNP will be larger than GDP if the people
or firms of a country hold large amounts
of the stocks and bonds of firms or
governments of other countries and derive
income from them.
5. GNP may be> or < than GDP in an open
economy.
1. It is the total money value of goods and
services produced in the domestic territory
of a country during a given year.
2. It does not include the income earned by
the nationals outside the country.
3. All the income produced in the country by
nationals or foreigners working in the
country are included in GDP.
4. GDP will be larger than GNP if much of
the income from a country’s production
flows to foreign persons or firms.
5. GDP = GNP in a closed economy.
 Net National Product (NNP)
 Net National Product is arrived at by subtracting depreciation from the GNP.

 In the process of production of goods and services, there will be some depreciation of
fixed capital also called as consumption of fixed capital.

 So NNP includes Net investments and GNP includes gross investment.

 NNP = GNP – Depreciation

 Difference between GNP and NNP
1. It is the sum of money value of goods and 1. It is the net money value of final goods
services produced by a nation during a and services produced by a nation during a
given year. given period.

2. GNP = C+I+G+ X-M 2. NNP is calculated by subtracting

C=Consumption I= Gross Investment G depreciation from GNP. Thus, NNP=GNP
Govenment purchase of goods and services X- – Depreciation.
M = Net Exports In other words, it includes net investment
instead of gross investment.

3. It does not give the correct picture of the 3. It gives the correct picture of the wealth of
wealth of a nation. a nation.
 Net Domestic Product (NDP)
 Net Domestic Product is arrived at by subtracting depreciation from the GDP.

 Depreciation is accounted for because factories, buildings etc., get depreciated over
their life time during their use in the production process.

 NDP = GDP – Depreciation

 Per Capita Income (PCI)
 Per capita Income is derived from dividing national income from the total population
of the country

 PCI = National Income / Population

 The Per capita income is calculated mainly because an increase in the real national
income, i.e. national income at constant price, may not improve the standard living of
the people if the Population has been growing at the same rate as the national income.

 For the Per capita income to rise, the national income at constant price should be
growing more than the growth of population.
 Gross Value Added (GVA)
 Gross Value Added represents the value added to the final product by a firm sans the
value of an intermediary consumption

 GVA = Value of Output – Value of Intermediary goods

 The net value added is obtained by deducting depreciation from gross value added

 It helps in avoiding the double counting of the product hence protect from over
estimation of goods and services.
 Green Gross Domestic Product (GGDP)
 Green GDP focusses on the impact of materialistic development on the Environment.

 GGDP focuses on the loss of Biodiversity, impact of Climate Change etc.

 GGDP uses physical indicator like Carbon dioxide emission per year, waste per capita
etc.

 Its impact is calculated in monetary loss and is deducted from the GDP

 Sustainable development is the need of the hour

THANK YOU